Price Mechanism And Policies Flashcards
Why are taxes more effective for collecting tax revenue when demand is more inelastic? (Memorise from notes)
With a more price inelastic demand, quantity demanded is less responsive to price changes. Quantity exchanged decreases by only a small amount, and thus tax revenue (which = tax per unit of output x units of output) is large
NOTE: price inelasticity/elasticity of demand has nothing to do with the magnitude of the tax which the govt has to impose. That’s decided by the govt beforehand, and the elasticity js determines the tax’s effects on equilibrium quantity (qty exchanged)
What is the economic reasoning behind the loss of allocative inefficiency when taxes are imposed?
(Hint: deadweight loss, consumers, producers worse off, compare areas)
If the market was efficient to begin with, any government intervention that resulted in a deviation from this allocative efficient market outcome would lead to a loss of economic welfare —> and a loss of allocative efficiency
Consumers are worse off because:
They pay a higher price per unit, decreasing CS by area A__
enjoy fewer units and thus forfeits the CS from those units, decreasing CS by area B
Overall, CS decrease by area A+B, area A trf to govt
Producers are worse off because:
They retain less of the price of the good for each unit of output, decreasing PS by area C.
Sell fewer units and thus forefeet’s PS from those units, decreasing CS by area D
Area C trf to govt
Govt is better off, enjoying a tax revenue of A+C units
In total, the welfare losses by producers and consumers of area A+B is gained by no one, and is thus the DW loss incurred.
Elaborate on why black markets are an impt implementation problem with respect to taxes? Even if they can be prevented, what is the trade off?
Black markets can be created when govt levies a high indirect tax on a certain product, eg cigarettes. Smokers will try to look for alt ways to consume the good, giving smugglers an incentive to import from foreign countries with low or no taxes on cigarettes, undercutting legal sellers and gaining profits.
To prevent this from happening, govt has to step up efforts to conduct regular checks and enforce rules, measures that take away scarce resources from alternative uses.
Explain why taxes are more effective as a policy discouraging consumption with a more price elastic demand
The more price elastic the demand, the more responsive quantity demanded is to price changes. Only a small price increase is needed to induce a sufficiently large decrease in Qd to eliminate shortage at Po, the original equilibrium price. Facing the supply curve of S1, Consequently, the smaller resultant increase in price will lead to a smaller increase in quantity supplied as well. Overall, a more price elastic demand will lead to a larger decrease in quantity exchanged
Describe the implications of subsidy spending on government budget
Subsidy spending, if not compensated with decreased spending in other areas, will lead to a worsening of government budget.
For a govt intent on maintaining its budget position, spending on subsidies will have to come at the expense of spending in other areas such as healthcare, education. Govt thus has to weigh the MSB and MSC of spending in different areas so as to arrive at the optimal allocation of resources.
Alternatively, govt could choose to raise taxes, however this comes with another set of problems to consider, such as erosion of incentive to work, save and invest.
Explain how black markets can undermine effectiveness of subsidies
When indirect subsidies lower the price of the goods in a country below the price of the same good in other countries, this creates an opportunity for profits to be made by purchasing the good at a subsidised price at home and then selling it at higher prices in other countries. Even if govt passes laws to prohibit the export of subsidised necessities, a high enough price differential will create incentive for smugglers to take the risk anyway. Undermines effectiveness of subsidies in keeping necessities affordable and available to the locals
Govt has to step up efforts to …
Explain the effect of PED on subsidies’ effectiveness in lowering the prices of necessities
More effective w a more price inelastic demand. The more price inelastic the demand, the less responsive qty dded is to price changes. A large decrease in price is needed to induce a sufficiently large increase in quantity demanded to eliminate shortage at original equilibrium price Po. Hence, a more price inelastic demand will result in a greater fall in prices.
Explain the effect of PED on subsidies’ effectiveness in encouraging consumption of a good
Effectiveness increases with a more price elastic demand. The more price elastic the demand, the more responsive qty dded is to price changes. A small decrease in price is enough to induce a sufficiently large increase in Qd to eliminate surplus. Facing the supply curve of S1, the small decrease in price causes a small resultant decrease in qty supplied. Hence, a more price elastic demand will lead to a larger increase in qty exchanged.
What is the general framework for bringing in price elasticity in a part (a) essay?
Supply of housing is price inelastic due to (STATE REASON: long construction period needed to build houses). An increase in px of housing will lead to less than proportionate increase in supply of housing.
STATE SIGNIFICANCE: A large increase in px needed to clear shortage at Po, given the increase in demand for housing
What is a good DDSS part A intro ?
The eqm price of housing is determined by forces of DD and SS in the housing market. _____state factors___ have caused rental prices to soar.
What is a limitation of the price ceiling? (Equity)
Even if the government were successful in keeping the price down, fewer units of the good is available in the market with a price ceiling. While the price ceiling may make the good more affordable, benefitting some, the decrease in availability of the good hurts other groups of consumers
