4: Government Intervention

Question 1

What are indirect taxes?

Answer 1

Indirect taxes are imposed on spending to buy goods and services. They are paid partly by consumers to the government by producers.

Question 2

What are the two types of indirect taxes?

Answer 2

1. Excise taxes - imposed on particular goods and services such as cigarettes or petrol.
2. Taxes on spending on all (or most) goods and services such as general sales taxes or value added taxes.

Question 3

What are direct taxes?

Answer 3

The payment of the tax by the taxpayer directly to the government.

Question 4

How do excise taxes effect allocation or resources?

Answer 4

Excise taxes increase the price paid by consumers and lower the price received by producers, causing them to produce less and thereby changing the price signals and incentives. Thus, resources are reallocated.

Question 5

Does an excise tax result in allocative efficiency or inefficiency?

Answer 5

This depends on the degree of allocative efficiency in the economy before the tax is imposed. If it begins with efficient allocation of resources the excise tax creates allocative inefficiency and vice versa.

Question 6

Why would the government impose excise taxes?

Answer 6

1. It is a source of government revenue.
2. They discourage the consumption of goods that are harmful to individuals - e.g. cigarettes, alcohol, gambling.
3. They can be used to redistribute income - e.g. taxes on expensive cars, boats and jewellery. The government can specifically tax goods that can only be afforded by high-income earners.
4. They can improve the allocation of resources by correcting negative externalities.

Question 7

What is a vice tax?

Answer 7

A tax on goods and services that the government wishes to decrease consumption of such as cigarettes or gambling.

Question 8

What are specific taxes?

Answer 8

A fixed amount of tax per unit of the good or service sold. For example, $5 per packet of cigarettes.

Question 9

What is an ad valorem tax?

Answer 9

A fixed percentage of the price of the good or service such that the amount of tax increases as the price of the good or service increases.

Question 10

How is the supply curve effected with specific and ad valorem taxes?

Answer 10

With specific taxes the supply curve shifts left to a parallel supply curve. With ad valorem the new supply curve is steeper than the original supply curve. The amount of tax per unit increases as the price increases.

Question 11

How can you calculate the final price received by producers and consumers after a tax using a graph?

What about government revenue?

Answer 11

You have S1 and D. Where they intercept is P*. You have S1 + tax. Where this intercepts with D is Pc (consumer price). Draw a vertical line down from this interception, which meets with Q at Qt. Where this vertical line meets S1 is Pp (producer price), as this is how much they receive given that the tax is government revenue.

Government revenue is shown by Qt (the new quantity after the tax) times by Pc-Pt, which is the tax.

Question 12

What are the market outcomes following a tax?

Answer 12

1. The equilibrium quantity produced and consumed falls from Q* to Qt.
2. The equilibrium price increases from P* to Pc, which is the price paid by consumers.
3. Consumer expenditure on the good is given by the price of the good per unit times the quantity of units bought. It changes from P* x Q* to Pc x Qt.
4. Price received by the firm falls from P* to Pp.
5. The government receives tax revenue of Q* x (Pc-Pp)
6. There is an under-allocation of resources to the production of the good as Qt is less that the equilibrium quantity. This means that there is dead weight loss.

Question 13

Consequences of taxes on consumers:

Answer 13

Consumers:
The price they pay increases, and the quantity available decreases, which makes them worse of as they pay more for a good they receive less of.

Society as a whole:

Question 14

Consequences of taxes on producers:

Answer 14

Producers:
The price they receive decreases, and the quantity they supply decreases, thus their TR decreases as both factors (P*Q) decrease as a result of the tax.

Question 15

Consequences of taxes on workers:

Answer 15

Workers:
A lower output, as quantity decreases, means that fewer workers are needed to produce it, meaning that tax could lead to unemployment.

Question 16

Consequences of taxes on society as a whole:

Answer 16

Society as a whole is worse off as a result of the tax, because there is an under-allocation of resources to the production of the good.

Question 17

How does a tax change the supply function?

Answer 17

Qs = C + dP

When there is a tax, there is an upwards (leftwards) shift of the function by t units. We therefore replace P with P - t. The new supply function becomes:

Qs = C + d(P - t)

Question 18

How do you graph using the supply and demand function with a tax?

Answer 18

We know that when there is a tax Qs = C + d(P-t) so when there is a tax set this equal to the given Qd equation to solve for P. Put P back into either equation to find Q.

Question 19

How does consumer and producer surplus change graphically after the imposition of a tax? Describe the other areas of the graph.

Answer 19

Where it used to be the area above P*, it is now the area above Pc until the Demand curve. Producer surplus after tax is the area below Pp until the original S1 curve. The rectangle in between is government revenue. The small triangle left is welfare/deadweight loss.

Question 20

Do marginal analysis on the point Qt from the consumers perspective:

Answer 20

At this point MB>MC and consumers would benefit from buying more of the good. Too little of the good is produced and consumed relative to the social optimum. This is where the welfare loss is.

Question 21

How can you graphically calculate consumer surplus?

Answer 21

It is the intercept of the demand curve (what consumers are willing to pay) minus the actual price paid by consumers * quantity purchased/2.

Question 22

How do you graphically calculate consumer surplus after tax?

Answer 22

It is the intercept of the demand curve (what consumers are willing to pay) minus the new actual price paid by consumers (Pc) * new quantity purchased (Qt) / 2.

Question 23

How do you graphically calculate producer surplus?

Answer 23

The price received by consumers minus the intercept of the supply curve * quantity purchased / 2.

Question 24

How do you graphically calculate producer surplus after tax?

Answer 24

The new price received by consumers (Pp) minus the intercept of the supply curve * new quantity purchased (Qt) / 2.

Question 25

What is the tax incidence?

Answer 25

Upon whom the burden of tax falls.

Question 26

What does the tax incidence depend on?

Answer 26

Whether the consumer or supplier has a larger burden depends on the PED and PES.

Question 27

How do you calculate the tax burden on consumers and producers?

Answer 27

incidence of consumers = (Pc-P*) x Qt

incidence of producers = (P*-Pp) x Qt

Question 28

How does PED effect the tax incidence? Why?

Answer 28

When demand is inelastic, most of the tax incidence is on the consumers, when demand is elastic most of the tax incidence is on the producers.

This is because when the demand graph is steeper, a shift in the supply curve will mean a higher jump from the original. When you draw a vertical line down, there is a smaller amount after P*. Obviously don’t write this, but you can draw it in a graph.

Examples: tax on cigarettes (a necessity due to addictions) and tax on bath salts (a luxury)

Question 29

What is a subsidy?

Answer 29

Assistance by the government to individuals or groups of individuals, such as firms, consumers, industries or sectors of an economy.

Question 30

What is a specific subsidy?

Answer 30

A fixed amount of cash payments by the government per unit of output.

Question 31

Why would governments grant subsidies?

Answer 31

1. Subsidies can be used to increase revenues and hence income of producers - this is commonly done for producers of agricultural products.
2. Subsidies can be used to make certain goods, usually necessities, affordable to low income consumers - e.g. a food staple like bread
3. Subsidies can be used to encourage production and consumption of particular goods and services that are believed to be desirable for consumers - e.g. education, vaccinations.
4. Subsidies can be used to support the growth of particular industries in the economy - e.g. solar power, ethanol production to promote bio fuels.
5. Subsidies can encourage exports of certain goods.
6. Subsidies improve the allocation of resources by correcting positive externalities.

Question 32

What are perverse subsidies?

Answer 32

Subsidies that have adverse effects on the environment and/or economy in the long run, such as subsidies on fossil fuels.

Question 33

What does a subsidy look like graphically?

Answer 33

It is a rightward shift of the supply curve.

Question 34

What are the market outcomes following a subsidy?

Answer 34

1. Quantity moves from Q* (market equilibrium quantity) to Qsb.
2. Consumer price moves down from P* (market equilibrium price) to Pc.
3. Producer price moves up from P* (market equilibrium price) to Pp.
4. The amount of subsidy given can be calculated by (Pp-Pc) x Qsb.
5. There is an overallocation of resources as Qsb>Q*.

Question 35

Consequences of subsidies for consumers?

Answer 35

Consumers are affected by the fall of the price of the good from P* to Pc, the fall meant that the quantity purchased increased from Q* to Qsb. Both of these changes make them better off.

Question 36

Consequences of subsidies for producers?

Answer 36

Producer price increases from P* to Pp, increasing revenue and therefore income. The quantity produced also increases from Q* to Qsb. Both of these things make producers better off.

Question 37

Consequences of subsidies for the government?

Answer 37

The government must pay the subsidy, which is a burden on its budget. To obtain the revenues for the subsidy, the government may have to reduce expenditures elsewhere in the economy, or it may have to raise taxes or run a budget deficit, which is where government expenditures are higher than tax revenues.

Question 38

Consequences of subsidies for the workers?

Answer 38

Since quantity produced increased from Q* to Qsb, more workers are required meaning unemployment could decrease.

Question 39

Consequences of subsidies for society as a whole?

Answer 39

Society as a whole is worse off due to the overallocation of resources given the increase in production of the good.

Question 40

Consequences of subsidies for the foreign producers?

Answer 40

If the subsidy is granted on exports, it lowers the price and increases the quantity of exports. While this is positive for foreign producers, it is negative for the producers of other countries who may be unable to compete with the lower price of the subsidised good.

Question 41

How does the supply function change with a subsidy?

Answer 41

It goes from Qs = c + dP to Qs = c + d(P + s)

Question 42

How do you calculate consumer expenditure with a subsidy?

Answer 42

Consumer expenditure = Qsb x Pc

Question 43

How do you calculate producer revenue with a subsidy?

Answer 43

Producer revenue = Qsb x Pp

Question 44

How do you calculate government expenditure with a subsidy?

Answer 44

Two ways:

subsidy per unit (Pp - Pc) x Qsb

or

Producers revenue - consumer expenditure

Question 45

What happens to consumer and producer surplus with a subsidy?

Answer 45

They both increase.

Question 46

Where is the gain in consumer and producer surplus in a graph with subsidy?

Answer 46

The consumer surplus is now the area under the demand curve and above Pc, until Qsb. Therefore the gain in consumer surplus is the area under the demand curve between Pc and P*, until Qsb.

The producer surplus is the area above the original supply curve S1, until Pp and until Qsb. Therefore the gain in producer surplus is the area above the original supply curve between Pp and P* until Qsb.

Question 47

Why is there welfare loss with subsidies?

Answer 47

The gain to society decreases as although producer and consumer benefit increases, there is a small area on the graph (the little triangle) which is lost. The government expenditure is equal to the gain in producer and consumer surplus, plus this triangle. This is because the subsidy caused overproduction relative to what is socially desirable, leading to an overallocation of resources.

Question 48

Evaluate whether a subsidy leaves society better off:

Answer 48

The granting of a subsidy results in greater consumer and producer surplus; however, society loses due to government spending on the subsidy. Since the loss from government spending is greater than the gain in producer and consumer surplus, welfare loss results, reflecting allocative inefficiency, which in this case is due to overallocation of resources due to overproduction.

Question 49

How do you calculate consumer surplus with a subsidy?

Answer 49

The P intercept of the demand curve (willingness to pay subtract the actual price paid, (Pc) * Qsb / 2

Question 50

How do you calculate producer surplus with a subsidy?

Answer 50

The actual price received (Pp) subtract the P intercept of the ORIGINAL supply curve (willingness to accept) * Qsb / 2

NB: DO NOT USE S2

Question 51

How can you calculate welfare loss after a subsidy?

Answer 51

Take the pre-subsidy sum of consumer and producer surplus and subtract the post subsidy sum of social benefits which is the sum of consumer and producer surplus minus government expenditure).

An easier way is thinking of it is: (Pp-Pc)(Qsb-Q)/2

Question 52

What are price controls?

Answer 52

They refer to the setting of minimum or maximum prices by the government so that prices are unable to adjust to their equilibrium level determined by demand and supply.

Question 53

What is a price ceiling?

Answer 53

A legal maximum price set by the government for a particular good.

Question 54

How would you draw a price ceiling graph?

Answer 54

Supply. Demand. Pe and Qe but then a line representing Pc. Then draw lines down from S and D to Qs and Qd respectively. Indicate a shortage as Qd > Qs.

Question 55

Examine the (unintended) consequences of price ceilings:

Answer 55

1. Shortages - at Pc not all who are willing and able to buy the product are able to do so.
2. Non-price rationing - shortages mean that the price mechanism is no longer able to achieve its rationing function. Qs must be distributed with non price rationing.
3. Underground markets - unrecorded transactions that are usually illegal. Sellers buy the good at a legal price and resell it at a price above the legal maximum.
4. Under-allocation of resources, allocative inefficiency.
5. Welfare loss

Question 56

What are methods of non price rationing?

Answer 56

1. Waiting in line and the first-come first-served principle,
2. The distribution of coupons to all interested buyers, so that they can purchase a fixed amount of the good in a given time period.
3. Favouritism: the sellers can sell the good to their preferred customers.

Question 57

Do consumers gain or lose from a price ceiling?

Answer 57

Some gain and some lose as those who are able to buy the good at the lower price gain but some consumers remain unsatisfied as at the ceiling price there is not enough of the good to satisfy all demanders.

They gain area c but lose area b.

Question 58

Do producers gain or lose from a price ceiling?

Answer 58

Producers are worse off because they sell a smaller quantity of the good at a lower price. Their revenues drop from PeQe to PcQs

Question 59

Do workers gain or lose from a price ceiling?

Answer 59

The fall in output from Qe to Qs means that some workers will be fired, resulting in unemployment.

Question 60

Does the government gain or lose from a price ceiling?

Answer 60

There will be no gains or losses for the government budget, yet the government may gain in political popularity amongst the consumers that are better off.

Question 61

Examples of price ceilings?

Answer 61

The most common is rent control and food price controls. These are considered to be necessities so it is important low income earners have access.

Question 62

Consequences of rent controls:

Answer 62

1. Housing becomes more affordable to low income earners.
2. A shortage of housing.
3. A smaller quantity of housing at the legally maximum rent than at the free market rent.
4. Long waiting lists of interested tenants.
5. An underground market where tenants pay above the legal maximum.
6. Run down and poorly maintained rental housing because it is unprofitable for landlords to maintain or renovate their rental units since low rents result in low revenues.

Question 63

How do you calculate shortage?

Answer 63

Qd - Qs

Question 64

How do you calculate changes in consumer expenditure?

Answer 64

Before price ceiling: Pe * Qe

After price ceiling: Pc * Qs

Question 65

How do you calculate changes in producer revenue?

Answer 65

Before price ceiling: Pe * Qe

After price ceiling: Pc * Qs

Question 66

What is a price floor?

Answer 66

A legally set minimum set by the government.

Question 67

Why would the government impose a price floor?

Answer 67

1. To provide income support for farmers by offering them prices for their products that are above market determined prices.
2. To protect low-skilled, low-wage workers by offering them a wage that is above the level determined in the market.

Question 68

Unintended consequences of price floor?

Answer 68

1. Surpluses
2. Government measures to dispose of surplus - storage, exporting it but countries won’t want to buy it at the high price, or send it as aid which could flood markets
3. Firm inefficiency
4. Allocative inefficiency
5. Welfare loss

Question 69

Do consumers gain or lose from a price floor?

Answer 69

Lose because they have to pay a higher price for less of the good.

Question 70

Do producers gain or lose from a price floor?

Answer 70

Some gain as they receive a higher price and produce a larger quantity, and since the government buys the surplis, they increase their revenues.

Question 71

Do workers gain or lose from a price floor?

Answer 71

They are likely to gain as employment increases in account of greater production of the good.

Question 72

Does the government gain or lose from a price floor?

Answer 72

When the government buys the excess supply, this is a burden on its budget, meaning it has less money to spend on other activities in the economy. The cost may come out of taxes. In addition storing the surplus or subsidising it for export is costly. Dumping may lead to political tensions.

Question 73

How do price floors effect other countries?

Answer 73

If surpluses of agricultural products are sold to other countries at a lower world price, countries that do not have price supports are forces to sell their own agricultural products at low world prices. The low prices mean that suppliers decrease production, due to the law of supply, meaning an under-allocation of resources.

Question 74

Are price floors good for the world?

Answer 74

No as overall, price floors lead to a global misallocation of resources as they cause high cost producers to produce more and low cost producers to produce less than the social optimum, resulting in a waste of resources.

Question 75

Consequences of minimum wages in the economy:

Answer 75

1. Labour surplus and unemployment
2. Illegal workers at wages below the minimum wage, such as illegal immigrants.
3. Misallocation of labour resources.
4. Misallocation in the product market - firms that rely on unskilled workers experience an increase in their cost of production.
5. Welfare loss - maybe read this part.

Question 76

Draw a diagram illustrating the problems of having a fixed price:

Answer 76

You might have a fixed price for theatre seats for example. The supply curve is a vertical line given that there are a fixed number of seats. Where the downwards sloping demand curve meets the supply curve is Pe. Above or below that however is Pfx (fixed price). If above then there will be an excess of seats equal to the line (that completes the triangle). If below, there will be a shortage of seats as at that price many people want them.