1 3 GOVERNMENT INTERVENTION INDIRECT TAXES SUBSIDIES 3

1. 3 GOVERNMENT INTERVENTION (INDIRECT TAXES & SUBSIDIES) 3. 1 INTERNATIONAL TRADE (RESTRICTIONS ON FREE TRADE: TRADE PROTECTION) 2. 3 MACROECONOMIC OBJECTIVES (EQUITY IN THE DISTRIBUTION OF INCOME)

1. 3 Government intervention Why Governments Intervene In Markets: The government tries to combat market inequities through regulation, taxation, and subsidies. Governments may also intervene in markets to promote general economic fairness. Maximizing social welfare is one of the most common and best understood reasons for government intervention. Examples of this include breaking up monopolies and regulating negative externalities like pollution. Governments may sometimes intervene in markets to promote other goals, such as national unity and advancement.

1. 3 Government intervention (Indirect taxes & Subsides) Indirect taxes An indirect tax is a tax collected by an intermediary i. e. seller, from the person who bears the ultimate economic burden of the tax i. e. consumer. It is imposed on expenditure. In simple terms, it is a tax which is imposed on goods and services sold. It is usually added to the cost of the good or service and charged from the ultimate consumer. The seller will then file a return to the government on all the taxes he has collected from the consumer.

1. Explain why governments impose indirect (excise) taxes. The main reasons for government imposing taxes can be: To generate Government revenues: excise duties on beers, wines and spirits are price inelastic in demand, so tax price increases by levying specific alcohol and tobacco taxes raise consumer expenditures as a whole on these categories and therefore taxation revenues; To discourage consumption: Government might use taxes to discourage consumption of certain demerit goods such as cigarettes. To alter the pattern of consumption: Government might use direct taxes a mean to alter the consumption pattern of its population. Certain goods can be made more price attractive through lower taxes while goods which have high marginal social cost can be made expensive through taxation.

2. Distinguish between specific and ad valorem taxes. Specific tax is a flat rate of tax whereas ad valorem tax is a percentage tax. Ad valorem literally the term means “according to value. ” It is imposed on the basis of the monetary value of the taxed item. A specific tax is when specific amount is imposed upon a good, for example $10 on each mobile phone sold; whereas ad valorem tax is expressed as a percentage of the selling price e. g. 12% of the sales. The amount of specific tax changes in the same proportion as the quantity sold increase, whereas, in ad valorem the tax collected is more at higher prices then at lower prices.

3. Draw diagrams to show specific and ad valorem taxes, and analyses their impacts on market outcomes.

4. Discuss the consequences of imposing an indirect tax on the stakeholders in a market, including consumers, producers and the government. Imposition of tax results in three economic observations. Incidence: Incidence of tax means the party who actually pays the tax. Government revenue: the amount of tax government will receive as revenue Resource allocation: the amount of fall in quantity demanded and produced created by the tax.

A Tax on Sellers A tax on sellers shifts the S curve up by the amount of the tax. The price buyers pay rises, the price sellers receive falls, eq’m Q falls. Effects of a $1. 50 per unit tax on sellers P PB = $11. 00 S 2 Tax S 1 $10. 00 PS = $9. 50 D 1 430 500 Q

A Tax on Buyers Effects of a $1. 50 per unit tax on buyers A tax on buyers shifts P the D curve down by the PB = $11. 00 amount of $10. 00 the tax. Tax S 1 PS = $9. 50 The price buyers pay rises, the price sellers receive falls, eq’m Q falls. D 1 D 2 430 500 Q

The Incidence of a Tax: how the burden of a tax is shared among market participants P Because of the tax, buyers pay $1. 00 more, PB = $11. 00 Tax S 1 $10. 00 PS = $9. 50 sellers get $0. 50 less. D 1 D 2 430 500 Q

The Outcome Is the Same in Both Cases! The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! P What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. PB = $11. 00 Tax S 1 $10. 00 PS = $9. 50 D 1 430 500 Q

4. Discuss the consequences of imposing an indirect tax on the stakeholders in a market, including consumers, producers and the government. Incidence or tax burden When a tax imposed on a good or service increases the price by the amount of the tax, the burden of the tax falls on consumers. If instead it lowers wages or lowers prices for some of the other factors of production used in the production of the good or service taxed, the burden of the tax falls on

4. Discuss the consequences of imposing an indirect tax on the stakeholders in a market, including consumers, producers and the government. If the tax does not change the product’s price or factor prices, the burden falls on the owner of the firm —the owner of capital. If prices adjust by a fraction of the tax, the burden is shared. The incidence of tax will be shared between the consumers and producers, depending on the price elasticity of demand (PED) and the price elasticity of supply (PES) for that product (which we will discuss later). If we assume that the burden is equally shared by both the consumers and the producers then the size of incident is equal. This means the incidence of tax is equally distributed by both the consumer and producer.

4. Discuss the consequences of imposing an indirect tax on the stakeholders in a market, including consumers, producers and the government. Government revenue Putting taxes on goods and services generates revenue for the government. Figure shows the shaded region as tax revenue for government i. e. CYXP 1. The implication will be a fall in output from Qe to Q 1 and thus the consumption and production of the

Total Revenue & Burden of Taxation

The Effects of a Tax P Without a tax, CS = A + B + C A PS = D + E + F Tax revenue = 0 Total surplus = CS + PS = A + B + C + D + E + F S B PE D C E D F QT QE Q

The Effects of a Tax P With the tax, CS = A PS = F Tax revenue = B + D Total surplus = A + B + D + F The tax causes total surplus to fall by C + E A PB S B D C E PS D F QT QE Q

The Effects of a Tax P C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax. DWL is the loss of efficiency. A PB S B D C E PS D F QT QE Q

About the Deadweight Loss P Because of the tax, the units between QT and QE are not sold. PB The value of these units to buyers is greater than the cost of producing PS them, so the tax has prevented some mutually beneficial trades. S D QT QE Q

5. Explain, using diagrams, how the incidence of indirect taxes on consumers and firms differs, depending on the price elasticity of demand on the price elasticity of supply. When PED is greater than PES Where PED is greater than PES, it implies that consumers are more sensitive to price changes as compared to suppliers. Thus the incidence of tax will be more on the suppliers because if too much burden of tax is passed on to the consumers then the demand will fall drastically. Therefore, this time the price paid by buyers barely rises;

5. Explain, using diagrams, how the incidence of indirect taxes on consumers and firms differs, depending on the price elasticity of demand on the price elasticity of supply. When PES is greater than PED When the supply curve is relatively elastic, the bulk of the tax burden is borne by buyers. This is because PED as compared to PES is elastic, which means; consumers are not that price sensitive and will not reduce their consumption even if the prices rise. Because the PES is elastic, suppliers will stop the supply if the cost of production goes

5. Explain, using diagrams, how the incidence of indirect taxes on consumers and firms differs, depending on the price elasticity of demand on the price elasticity of supply. PED is equal to PES In this case both the producer and consumer will share equal burden of tax. Videos: Examining the effect of an excise tax on an inelastic good – Cigarettes Examining the Effect of an Excise Tax on an Elastic Good – Candy bars

Elasticity and Tax Incidence CASE 1: Demand is more inelastic than Supply P Buyers’ share of tax burden PB S Tax Price if no tax Sellers’ share of tax burden In this case, buyers bear most of the burden of the tax. PS D Q

Elasticity and Tax Incidence CASE 2: Supply is more inelastic than Demand P Buyers’ share of tax burden PB Price if no tax Sellers’ share of tax burden In this case, sellers bear most of the burden of the tax. S Tax PS D Q

Elasticity and Tax Incidence If buyers’ price elasticity > sellers’ price elasticity, buyers can more easily leave the market when the tax is imposed, so buyers will bear a smaller share of the burden of the tax than sellers. If sellers’ price elasticity > buyers’ price elasticity, the reverse is true. The more Inelastic the more the burden of taxation is shifted to that party. When the curve is perfectly inelastic that party pays all the tax and when the curve is perfectly elastic the other party pays all the

Elasticity and Tax Incidence

When the curve is perfectly inelastic that party pays all the tax

When the curve is perfectly elastic the other party pays all the tax.

6. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus). Step 1 Use the linear functions given to draw the relevant demand supply curves and to identify the equilibrium price and quantity. E. g. If the demand supply functions for a product are QD = 2000 – 200 P and QS = -400 + 400 P.

6. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus). Step 2 Change the supply function by taking the amount of the specific tax away from P, simplify the equation, and then draw the new supply curve. E. g. If the government imposes a specific tax of $0. 75, then the supply function is changed, because the producers will have to pay the tax and so the price they receive falls by $0. 75. Thus, the price in the equation is (P – 0. 75) at each level. If we put this in the equation, we get QS = - 400 + 400(P - 0. 75). Then, we can simplify the supply function and draw the new supply curve. � QS = - 400 + 400(P - 0. 75) � QS = - 400 + (400 x. P) – (400 x 0. 75) � QS = - 400 + 400 P – 300

6. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus).

6. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus). Step 3 Identify the effects that are requested by the question in terms of price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus or producer surplus. E. g. In the diagram above, the new equilibrium price is $4. 50 and the new quantity demanded is 1100 units. Consumer expenditure goes from 1200 units at $4 = $4, 800, to 1100 units at $4. 50 = $4, 950 – an increase of $150. Producer revenue, after paying the tax of $0. 75 per unit, goes from 1200 units at $4 = $4, 800 to 1100 units at $3. 75 = $4, 125 – a fall of $675. Government revenue is 1100 units at a tax per unit of $0. 75 = $825.

6. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus). Using Linear Equations to Calculate the Effect of an Indirect Tax (for HL students)

6. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus). Step 1 Calculate the original equilibrium price and quantity from the demand supply functions. E. g. If the demand supply functions for a product are QD = 2000 – 200 P and QS = -400 + 400 P. Then equilibrium can be calculated by setting the equations against each other, so that: � QD = QS, � 2000 – 200 P = -400 + 400 P � 2400 = 600 P � P = $4 Substitute $4 as P in either equation to get the equilibrium quantity, which is 1, 200 units.

6. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus). Step 2 Rearrange the supply function to take account of the specific tax that is set and then find the new equilibrium. E. g. If the government imposes a specific tax of $0. 75, then the supply function is changed, because the producers will have to pay the tax and so the price they receive falls by $0. 75. Thus, the price in the equation is (P - 0. 75) at each level. If we put this in the equation, we get QS = - 400 + 400(P - 0. 75). Then, we can simplify the supply function. QS = - 400 + 400(P - 0. 75) � QS = - 400 + (400 x. P) – (400 x 0. 75) � QS = - 400 + 400 P – 300 �

6. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus). Now, equilibrium is where the old demand equation meets the new supply equation: � 2000 – 200 P = -700 + 400 P � 2700 = 600 P � P = $4. 50 Substitute $4. 50 as P in either equation to get the new equilibrium quantity, which is 1, 100 units.

6. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus). Step 3 Calculate the further effects that are requested by the question in terms of consumer expenditure, producer revenue, government revenue, consumer surplus or producer surplus. E. g. Consumer expenditure goes from 1200 units at $4 = $4, 800, to 1100 units at $4. 50 = $4, 950 – an increase of $150. Producer revenue, after paying the tax of $0. 75 per unit, goes from 1200 units at $4 = $4, 800 to 1100 units at $3. 751 = $4, 125 – a fall of $675. Government revenue is 1100 units at a tax per unit of $0. 75 = $825.

7. Explain why governments provide subsidies, and describe examples of subsidies. A subsidy is a form of financial assistance paid by the government to a business or economic sector. Why subsidies are given? Subsidies might be given to: Lower the cost of necessary goods which might affects a major part of population. Example, subsidies given to essential food items and oil (in India). Guarantee the supply of merit goods, which the government thinks consumers should consume. Help domestic firms become more competitive in the international market, also known as protectionism.

8. Draw a diagram to show a subsidy, and analyze the impacts of a subsidy on market outcomes. Subsidy reduces the cost of production. Thus the supply curve for the product shifts vertically downwards by the amount of subsidy provided.

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government. Impact of subsidies on Producers: Subsidies are monetary benefits provided to the producer by the Government on account of production of certain commodity. Subsidies lead to increase in producer revenue. Due to subsidy the supply curve (S-subsidy) will shift vertically downwards by the amount of subsidy. This reduces the cost of production and more is now being supplied at every price.

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government. Through the diagram, we can see, initially the market was at equilibrium with Qe being supplied & demanded at Price (Pe). Government provides subsidy WZ per unit. Producers lower their prices to P 1 Increase output till a new equilibrium is reached at Q 1 The producer will however not pass all the subsidy benefit to the consumer. Initial producer revenue was OPe. XQe which now increases to ODWQ 1.

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government. Impact of subsidies on Consumers will now consume more of the product due to lower prices. Consumers pay less as the prices fall from Pe to P 1, however, they end up consuming more from Qe to Q 1. It is difficult to say by how much the consumer expenditure will increase or fall as it will depend on their

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government. Impact of subsidies on Government will end up paying a subsidy of P 1 DWZ. Obviously, this will involve an opportunity cost. Government will have to forego investments in other sectors of the economy in order to provide subsidy. At the end of the day, the burden usually lies on the taxpayer.

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government. When PED is elastic relative to PES The consumers do not benefit from a great fall but, because their demand is relative elastic, they increase their consumption by a significant amount.

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government. When PED is inelastic relative to PES Consumption of the product is increased and so is the revenue of the producer. The consumer benefit from a relatively large price fall, but their demand is relative inelastic, their consumption does not

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government. The more inelastic the curve, the more the benefit from the subsidy is kept by that party.

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government.

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government.

9. Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government. Because total surplus in a market is lower under a subsidy than in a free market, we can conclude that subsidies create economic inefficiency, known as deadweight loss. The deadweight loss in the diagram above is given by area H, which is the shaded triangle to the right of the free market quantity. Economic inefficiency is created by a subsidy because it costs a government more to enact a subsidy than the subsidy creates in additional benefits to consumers and producers.

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). Step 1 Use the linear functions given to draw the relevant demand supply curves and to identify the equilibrium price and quantity. E. g. If the demand supply functions for a product are QD = 2000 – 200 P and QS = -400 + 400 P.

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). Step 2 Change the supply function by adding the amount of the subsidy to P, simplify the equation, and then draw the new supply curve. E. g. If the government grants a subsidy of $0. 75 per unit, then the supply function is changed, because the producers receive the subsidy and so the price they receive rises by $0. 75. Thus, the price in the equation is (P + 0. 75) at each level. If we put this in the equation, we get QS = - 400 + 400(P + 0. 75). Then, we can simplify the supply function and draw the new supply curve. � QS = - 400 + 400(P + 0. 75) � QS = - 400 + (400 x. P) + (400 x 0. 75) � QS = - 400 + 400 P + 300

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus).

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). Step 3 Identify the effects that are requested by the question in terms of price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus or producer surplus. E. g. In the diagram above, the new equilibrium price is $3. 50 and the new quantity demanded is 1300 units. Consumer expenditure goes from 1200 units at $4 = $4, 800, to 1300 units at $3. 50 = $4, 550 – a decrease of $250. Producer revenue, after receiving the subsidy of $0. 75 per unit, goes from 1200 units at $4 = $4, 800 to 1300 units at $4. 25 = $5, 525 – an increase of $725. Government cost of the subsidy is 1300 units at a subsidy per

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). The gains of consumer surplus and producer surplus can be identified from the diagram and then calculated. The original consumer surplus was the triangle 4, 10, Y. So it is the area of that, which is ½ x $6 x 1200 = $3, 600. The new consumer surplus is the triangle 3. 50, 10, Z. So it is the area of that, which is ½ x $6. 50 x 1300 = $4, 225. The increase in consumer surplus is $4, 225 - $3, 600 = $625.

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). The original producer surplus was the triangle 4, 1, Y. So it is the area of that, which is ½ x $3 x 1200 = $1, 800. The new producer surplus is the triangle 4. 25, 1, X. So it is the area of that, which is ½ x $3. 25 x 1300 = $2, 112. 5. The increase in producer surplus is $2, 112. 5 - $1, 800 = $312. 5. [Out of interest, community surplus, which is consumer surplus + producer surplus, goes from $5, 400 to $6, 337. 50. This is an increase of $937. 50. The cost of the subsidy to the government is $975 (see above). So, it follows that the subsidy created a dead-weight loss of $975 - $937. 50 = $37. 50. This occurs because the extra hundred units produced because of the subsidy would not have been produced in a free market. The dead-weight loss is indicated by the triangle XYZ, and so it can also be calculated by finding the area of that triangle, which

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). Step 1 Calculate the original equilibrium price and quantity from the demand supply functions. E. g. If the demand supply functions for a product are QD = 2000 – 200 P and QS = -400 + 400 P. Then equilibrium can be calculated by setting the equations against each other, so that: QD = QS, � 2000 – 200 P = -400 + 400 P � 2400 = 600 P � P = $4 � Substitute $4 as P in either equation to get the equilibrium quantity, which is 1, 200 units.

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). Step 2 Rearrange the supply function to take account of the subsidy that is given and then find the new equilibrium. E. g. If the government grants a subsidy of $0. 75 per unit, then the supply function is changed, because the producers will get the subsidy and so the price they receive rises by $0. 75 per unit. Thus, the price in the equation is (P + 0. 75) at each level. If we put this in the equation, we get QS = - 400 + 400(P + 0. 75). Then, we can simplify the supply function. QS = - 400 + 400(P + 0. 75) � QS = - 400 + (400 x. P) + (400 x 0. 75) � QS = - 400 + 400 P + 300 � QS = -100 + 400 P �

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). Now, equilibrium is where the old demand equation meets the new supply equation: � 2000 – 200 P = -100 + 400 P � 2100 = 600 P � P = $3. 50 Substitute $3. 50 as P in either equation to get the new equilibrium quantity, which is 1, 300 units.

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). Step 3 Calculate the further effects that are requested by the question in terms of consumer expenditure, producer revenue, government revenue, consumer surplus or producer surplus. E. g. Consumer expenditure goes from 1200 units at $4 = $4, 800, to 1300 units at $3. 50 = $4, 550 – a decrease of $250. Producer revenue, after receiving the subsidy of $0. 75 per unit, goes from 1200 units at $4 = $4, 800 to 1300 units at $4. 252 = $5, 525 – a rise of $725. Government cost of the subsidy is 1300 units at a subsidy per unit of $0. 75 = $975.

10. Plot demand supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). Videos: Calculating the Effects of a Subsidy using Linear Equations (HL Only) The Effects of a Subsidy on Market Equilibrium

3. 1 International trade (Restrictions on free trade: Trade protection)

World price and comparative advantage World price: The price of a good that prevails in the world market for that good. The effects of free international trade can be shown by comparing the domestic price of a good without trade and the world price of the good. If a country has a comparative advantage, the domestic price will be below the world price, and the country will be an exporter of the good. If the country has a comparative disadvantage, the domestic price will be higher than the world price, and the country will be an importer of the good.

International Trade in an Exporting Country World price of good Z > domestic price of good Z. � Domestic producers increase production as the price moves up to the world price. � Domestic consumers decrease consumption as the price moves up to the world price. � The excess supply (surplus) will be exported to willing buyers in another country. The analysis of an exporting country yields two conclusions: � Domestic producers of the good are better off, and domestic consumers of the good are worse off. � Trade raises the economic well-being of the nation as a whole because the gains of producers exceed the losses of consumers.

Figure 3 How Free Trade Affects Welfare in an Exporting Country Price of Steel Price after trade Consumer surplus before trade Exports A B Price before trade World price D C Producer surplus before trade 0 Domestic supply Domestic demand Quantity of Steel Copyright © 2004 South-Western

A Country That Exports Soybeans Without trade, CS = A + B PS = C Total surplus = A + B + C With trade, CS = A PS = B + C + D Total surplus = A + B + C + D Soybeans P $6 $4 S exports A B C D gains from trade D Q

International Trade in an Importing Country World price of good T < domestic price of good T. � Domestic producers decrease production as the price moves down to the world price. � Domestic consumers increase consumption as the price moves down to the world price. � The excess demand (shortage) will be satisfied by imports from willing sellers in another country. The analysis of an importing country yields two conclusions � Domestic producers of the good are worse off, and domestic consumers of the good are better off. � Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers.

Figure 5 How Free Trade Affects Welfare in an Importing Country Price of Steel Consumer surplus after trade Domestic supply A Price before trade Price after trade 0 B C D Imports Producer surplus after trade World price Domestic demand Quantity of Steel Copyright © 2004 South-Western

World price and comparative advantage

Summary: The Welfare Effects of Trade PD < PW PD > PW direction of trade exports imports consumer surplus falls rises producer surplus rises falls total surplus rises Whether a good is imported or exported, trade creates winners and losers. But the gains exceed the losses.

The Welfare Effects of Trade

11. Explain, using a tariff diagram, the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government. Tariffs, or customs duties, are taxes on imported products, usually in an ad valorem form, levied as a percentage increase on the price of the imported product The imposition of tariffs leads to the following: Higher prices Domestic consumers face higher prices, which also means that there is a loss of consumer surplus. However, there is a gain in domestic producer surplus as producers are protected from cheap imports, and receive a higher price than they would have without the tariff. However, it is likely that there is an overall net welfare loss.

11. Explain, using a tariff diagram, the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government. The imposition of a tariff shifts up the world supply curve to World Supply + Tariff. The result is that domestic producers have been protected from cheaper imports from the rest of the World. Given that domestic consumers face higher prices, they also suffer a loss of consumer surplus. In contrast, domestic producers increase their producer surplus as they receive a higher price than they would have without the tariff. Increased market share also means that jobs will be protected in the domestic economy.

11. Explain, using a tariff diagram, the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government.

11. Explain, using a tariff diagram, the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government. Welfare loss However, the reduction in consumer surplus is greater than the increase in producer surplus. Even when adding the tariff revenue (area K, L, M, N) there is still a net loss. The net welfare loss is represented by the triangles X and Y.

11. Explain, using a tariff diagram, the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government. Distortion There is a potential distortion of the principle of comparative advantage, whereby a tariff alters the cost advantage that countries may have built up through specialization. Retaliation There is the likelihood of retaliation from exporting countries, which could trigger a costly trade war. However, in the short run tariffs may protect jobs, infant and declining industries, and strategic goods. Tariffs may also help conserve a nonrenewable scarce resource. Selective tariffs may also help reduce a trade deficit, and reduce consumption.

Analysis of a Tariff P Cotton shirts deadweight loss = D + F free trade CS = A + B + C + D + E + F PS = G Total surplus = A + B + C + D + E + F + G tariff CS = A + B PS = C + G Revenue = E Total surplus = A + B + C + E + G S A B $30 $20 C D E F G 25 40 70 80 D Q

Analysis of a Tariff P D = deadweight loss from the overproduction of shirts F = deadweight loss from the under$30 consumption of shirts $20 Cotton shirts deadweight loss = D + F S A B C D E F G 25 40 70 80 D Q

12. Calculate from diagrams the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government.

12. Calculate from diagrams the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government. Domestic producers previously sold 10 units at the world price of $8. After the tariff, they are paid $10 and sell 15. Domestic producers revenue before tariff: P world X Q domestic = $8 X 10 = $80. Domestic producer revenue after tariff: P tariff X Q new domestic = $10 X 15 = $150. Foreign producers receive the world price of $8, but their imports are reduced from 20 units to 10. Foreign produce revenue before tariff: P world X Q imports = $8 X (30 – 10) = $160 Foreign produce revenue after tariff: P world X Q new imports = $10 X (25 – 15) = $100

12. Calculate from diagrams the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government. Consumer surplus is calculated as the area of the surplus triangle, ½ (base X height). Consumer surplus before tariff: ½ ( highest price – P world ) X Q world = 0. 5(20 – 8) X 30 = $180 Consumer surplus after tariff: ½ ( highest price – P tariff ) X Q world = 0. 5(20 – 10) X 25 = $125 Government revenue is calculated as the amount of the tariff multiplied by the number of imports. Government revenue before tariff: $ 0 = no tax collected Government revenue after tariff: (P tariff – P world) X Q new imports = ($10 - $8) X (25 – 15) = $20 Deadweight loss of tariff = 2(0. 5(30 -25)X($10 -$8)) = $10

2. 3 Macroeconomic Objectives (Equity in the distribution of income) The role of taxation in promoting equity

13. Distinguish between direct and indirect taxes, providing examples of each, and explain that direct taxes may be used as a mechanism to redistribute income. An indirect tax is a tax collected by an intermediary i. e. seller, from the person who bears the ultimate economic burden of the tax i. e. consumer. It is imposed on expenditure. In simple terms, it is a tax which is imposed on goods and services sold. It is usually added to the cost of the good or service and charged from the ultimate consumer. The seller will then file a return to the government on all the taxes he has collected from the consumer. Examples GST (Goods and service tax) VAT (Value added tax) Consumers are charged a percentage of tax while purchasing a good/service and then the seller pays the tax collected to the Government.

13. Distinguish between direct and indirect taxes, providing examples of each, and explain that direct taxes may be used as a mechanism to redistribute income. Direct Taxes It is a tax paid directly to the government by the persons on whom it is imposed. Examples Tax imposed on peoples’ income-Income tax Tax on wealth – wealth Tax on firm’s profits. - corporate tax

14. Distinguish between progressive, regressive and proportional taxation, providing examples of each. Progressive Tax A tax in which people with more income pay a larger percentage in taxes. Example: Income tax (Direct Tax) Regressive Tax A tax in which people with more income pay a smaller percentage in taxes. Example: Sales Tax (Indirect Tax) Proportional Tax A tax in which people pay the same percentage of income in taxes regardless of their incomes. Example: Flat Tax (Direct Tax)

Examples of the Three Tax Systems regressive income tax % of income $50, 000 $15, 000 30% proportional tax % of income progressive tax % of income $12, 500 25% $10, 000 20% 100, 000 25 25, 000 25 200, 000 40, 000 20 50, 000 25 60, 000 30

15. Calculate the marginal rate of tax and the average rate of tax from a set of data. An average tax rate is the ratio of the total amount of taxes paid to the total tax base (taxable income or spending), expressed as a percentage. Let T be the total tax liability. Let B be the total tax base. Average tax rate = T / B

15. Calculate the marginal rate of tax and the average rate of tax from a set of data. A marginal tax rate is sometimes defined as the tax rate that applies to the last (or next) unit of the tax base (taxable income or spending). In plain English, the marginal tax rate is the tax percentage on the highest dollar earned. For example, in the United States, the top marginal tax rate is 39. 6%, but that rate applies only to earnings over $400, 000 per year; earnings under $400, 000 have a lower tax rate of 33% or less. That formal definition only holds true to the equation following when the denominator equals one unit of the tax base. In practice most decisions require the denominator to be a larger amount. The marginal tax rate equals the change in taxes divided by the change in tax base, expressed as a percentage. Let T be the total tax liability. Let B be the total tax base. Marginal tax rate = T/ B

16. Explain that governments undertake expenditures to provide directly, or to subsidize, a variety of socially desirable goods and services (including health care services, education, and infrastructure that includes sanitation and clean water supplies), thereby making them available to those on low incomes. Higher government spending on merit goods should yield a positive social rate of return which leads to an improvement in total economic welfare. There is a case for some form of government intervention to encourage increased consumption of merit goods. This might take the form of an explicit government subsidy to reduce the private marginal costs of consumption and cause an expansion of demand. The government often provides merit goods "free at the point of use" and then finances them through general taxation. Examples of merit goods that are largely state provided include primary health care and public schooling.

17. Explain the term transfer payments, and provide examples, including old age pensions, unemployment benefits and child allowances. A transfer payment is a payment from the government to an individual for which no good or service is exchanged. In order to be eligible to receive them, an individual has to fall below a certain income threshold or to be experiencing economic hardship. Transfer payments existing in most developed countries include: Unemployment benefits Social security benefits Nutritional subsidies Higher education grants and tuition subsidies Welfare benefits

18. Evaluate government policies to promote equity (taxation, government expenditure and transfer payments) in terms of their potential positive or negative effects on efficiency in the allocation of resources. A tax system that punishes innovation, productivity and hard work is clearly undesirable and should therefore be avoided. However, a tax system including progressive marginal income taxes combined with regressive indirect taxes ensures that both the rich and the poor share a portion of the nation’s tax burden. Yet it also ensures that those with the greatest ability to pay bear the largest burden while those whose ability to pay the lowest benefit from the public and transfer payments that the government provides. This reduces the inequality of income distribution and corrects for the market failures that results in

18. Evaluate government policies to promote equity (taxation, government expenditure and transfer payments) in terms of their potential positive or negative effects on efficiency in the allocation of resources. Progressive Tax A tax in which people with more income pay a larger percentage in taxes. Regressive Tax A tax in which people with more income pay a smaller percentage in taxes. Proportional Tax A tax in which people pay the same percentage of income in taxes regardless of their incomes. in-kind transfers to the poor given in the form of goods and services rather than cash

18. Evaluate government policies to promote equity (taxation, government expenditure and transfer payments) in terms of their potential positive or negative effects on efficiency in the allocation of resources.

Section 1. 3: Government intervention Price controls

19. Explain why governments impose price ceilings, and describe examples of price ceilings, including food price controls and rent controls. Price ceiling: A legal maximum on the price at which a good or service can be sold. A price ceiling may be set to prevent price from rising beyond a pre-determined level. A price ceiling will only have an effect on the market if it is set below the prevailing market clearing price. A price ceiling is also called a maximum price, and may be used if it is felt that the resource or commodity should be more widely available, as in the case of food or medicines, or where there are specific historical, political or cultural reasons why allowing price to rise to its natural level.

19. Explain why governments impose price ceilings, and describe examples of price ceilings, including food price controls and rent controls. The purpose of a price ceiling is to protect consumers of a certain good or service. By establishing a maximum price, a government wants to ensure the good is affordable for as many consumers as possible. Rent control is an example of a price ceiling.

20. Draw a diagram to show a price ceiling, and analyze the impacts of a price ceiling on market outcomes.

20. Draw a diagram to show a price ceiling, and analyze the impacts of a price ceiling on market outcomes. A price ceiling has an economic impact only if it is less than the free-market equilibrium price. An effective price ceiling will lower the price of a good, which decreases the producer surplus. The effective price ceiling will also decrease the price for consumers, but any benefit gained from that will be minimized by the decreased sales due to the drop in supply caused by the lower price. If a ceiling is to be imposed for a long period of time, a government may need to ration the good to ensure availability for the greatest number of consumers. Prolonged shortages caused by price ceilings can create black markets for that good.

20. Draw a diagram to show a price ceiling, and analyze the impacts of a price ceiling on market outcomes.

EXAMPLE 1: The Market for Apartments P Rental price of apts S $800 Eq’m w/o price controls D 300 Q Quantity of apartments

How Price Ceilings Affect Market Outcomes P A price ceiling above the equilibrium price is not binding – it has no effect on the market outcome. S Price ceiling $1000 $800 D 300 Q

How Price Ceilings Affect Market Outcomes P The equilibrium price ($800) is above the ceiling and therefore illegal. The ceiling is a binding constraint on the price, and causes a shortage. S $800 Price ceiling $500 shortage 250 400 D Q

How Price Ceilings Affect Market Outcomes P In the long run, supply and demand are more price-elastic. So, the shortage is larger. S $800 Price ceiling $500 shortage 150 450 D Q

21. Examine the possible consequences of a price ceiling, including shortages, inefficient resource allocation, welfare impacts, underground parallel markets and non-price rationing mechanisms. With a shortage, sellers must ration the goods among buyers. Some rationing mechanisms: (1) long lines (2) discrimination according to sellers’ biases These mechanisms are often unfair, and inefficient: the goods don’t necessarily go to the buyers who value them most highly. In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal.

22. Discuss the consequences of imposing a price ceiling on the stakeholders in a market, including consumers, producers and the government. Who benefits and who loses from this policy? Depends. There are 200, 000 fewer apartments supplied in the market at this lower price, so both consumers and producers lose out by not renting out apartments. This is the dead-weight loss triangle (DWL) in the graph. Those consumers who manage to find an apartment at this lower price gain because they now pay a price $200 lower than before, so their consumer surplus goes up (CS). Suppliers are the clear losers. They rent out fewer apartments and the producer surplus in the economy goes down (PS).

22. Discuss the consequences of imposing a price ceiling on the stakeholders in a market, including consumers, producers and the government.

What Can the Government do about the shortage created by the Binding Ceiling? Without Govt. interference, the market will be left with a shortage or excess demand. This could lead to illegal markets, long lines, bribery, etc… The Govt. could try to shift the demand curve to the left by providing subsidies for alternatives. The Govt. could try to shift the supply curve to the right by (i) subsidies to the producers to produce more, (ii) the Govt. could provide the good or service themselves, (iii) if the Govt. had stored some of the

23. Calculate possible effects from the price ceiling diagram, including the resulting shortage and the change in consumer expenditure (which is equal to the change in firm revenue). Step 1 Use the linear functions given to draw the relevant demand supply curves and to identify the equilibrium price and quantity. E. g. If the demand supply functions for a product are QD = 2000 – 200 P and QS = -400 + 400 P.

23. Calculate possible effects from the price ceiling diagram, including the resulting shortage and the change in consumer expenditure (which is equal to the change in firm revenue). Step 2 Draw the ceiling price onto the diagram, below the equilibrium price. Then indicate the quantity demanded and the quantity supplied at the ceiling price. Then calculate the shortage (excess demand) that is created by imposing the ceiling price. E. g. The government decided to impose a maximum price of $3. The quantity demanded is now 1, 400 units and the quantity supplied is 800 units, so the excess demand (shortage) is

23. Calculate possible effects from the price ceiling diagram, including the resulting shortage and the change in consumer expenditure (which is equal to the change in firm revenue). Step 3 Calculate from the diagram total expenditure and changes in expenditure. E. g. The total expenditure on the product before the ceiling price was $4 x 1200 units = $4, 800. The total expenditure on the product after the ceiling price was $3 x 800 units = $2, 400. Expenditure has fallen by $2, 400 or 50%. [Remember that the expenditure of the consumers is the same as the revenue of the producers. ]

23. Calculate possible effects from the price ceiling diagram, including the resulting shortage and the change in consumer expenditure (which is equal to the change in firm revenue). Step 4 Calculate any further effects that are requested by the question, in terms of the subsidy that might be necessary to eliminate the excess demand created by the minimum price and the total government expenditure on the subsidy. E. g. If there is an excess demand of 600 units, then the government, if they wish to rectify this, will need to shift the supply curve to the right by 600 units at every price. This would add 600 units to the supply function: Originally: QS = -400 + 400 P Now, it would need to be: QS 1 = -400 + 600 + 400 P = 200 + 400 P.

23. Calculate possible effects from the price ceiling diagram, including the resulting shortage and the change in consumer expenditure (which is equal to the change in firm revenue). As we can see from the diagram, producers will now produce at the equilibrium, where 1, 400 units are demanded and supplied at a price of $3. We can see from the original supply curve, without the subsidy, that in order to supply 1400 units, the producers need to receive $4. 50. Thus, the subsidy per unit is $1. 50. The total subsidy payment by

24. Explain why governments impose price floors, and describe examples of price floors, including price support for agricultural products and minimum wages. Price floor: A legal minimum on the price or service at which a good can be sold. A price floor, which is also referred to as a minimum price, sets the lowest level possible for a price. Price floors, and minimum prices, only have an effect if they are set above the actual market clearing price. There are many instances of governments in the real world setting price floors, such as setting a national minimum wage for labor to ensure that individuals are able to earn a ‘living wage’. In addition, given the instability of agricultural prices and the need to ensure food security, farm prices may be set which guarantee a minimum price to farmers.

25. Draw a diagram of a price floor, and analyze the impacts of a price floor on market outcomes.

EXAMPLE 2: The Market for Unskilled Labor Wage paid to unskilled workers W S $4 Eq’m w/o price controls D 500 L Quantity of unskilled workers

How Price Floors Affect Market Outcomes W A price floor below the equilibrium price is not binding – it has no effect on the market outcome. S $4 Price floor $3 D 500 L

How Price Floors Affect Market Outcomes W $5 The equilibrium wage ($4) is below the floor and $4 therefore illegal. The floor is a binding constraint on the wage, and causes a surplus (i. e. , unemployment). labor surplus S Price floor D 400 550 L

The Minimum Wage Min wage laws do not affect highly skilled workers. They do affect teen workers. Studies: A 10% increase in the min wage raises teen unemployment by 1 -3%. W unemployment S Min. wage $5 $4 D 400 550 L

26. Examine the possible consequences of a price floor, including surpluses and government measures to dispose of the surpluses, inefficient resource allocation and welfare impacts. A price floor is economically consequential if it is greater than the free-market equilibrium price. Price floors lead to a surplus of the product. Supply surpluses created by price floors are generally added to producer's inventory or are purchased by governments. Consumer surplus is the gain obtained by consumers because they can obtain a product for a lower price than they would be willing to pay. Producer surplus is the benefit producers get by selling at a price higher than the lowest price they would sell for.

27. Discuss the consequences of imposing a price floor on the stakeholders in a market, including consumers, producers and the government. Who wins and who loses with this policy? Clearly consumers lose because they now pay higher prices (CS in the graph on the right is smaller) and there are some consumer that are not going to buy, so there is dead-weight loss (DWL) on the consumer side. On the producer side, there are some producers who will not trade, so there is also some dead-weight loss (DWL) on the producer side. But, for those producers who do sell their product at a higher price, they gain more producer surplus (PS). Note how producer surplus has increased for those who sell.

27. Discuss the consequences of imposing a price floor on the stakeholders in a market, including consumers, producers and the government.

27. Discuss the consequences of imposing a price floor on the stakeholders in a market, including consumers, producers and the government.

What Can the Government do about the surplus created by the Binding floor? Without Govt. interference, the market will be left with a surplus. This will lead to overall less demand or sellers trying to get around the high prices by selling below the floor price which will be illegal. The Govt. could buy up the surplus from the producers. The surplus could then either be stored, destroyed or sold abroad all of which create their own set of problems. The Govt. could subsidies the purchase of the good or service to increase the demand for it. They could also advertise to increase demand or they could use a Quota.

28. Calculate possible effects from the price floor diagram, including the resulting surplus, the change in consumer expenditure, the change in producer revenue, and government expenditure to purchase the surplus. Step 1 Use the linear functions given to draw the relevant demand supply curves and to identify the equilibrium price and quantity. E. g. If the demand supply functions for a product are QD = 2000 – 200 P and QS = -400 + 400 P.

28. Calculate possible effects from the price floor diagram, including the resulting surplus, the change in consumer expenditure, the change in producer revenue, and government expenditure to purchase the surplus. Step 2 Draw the floor price onto the diagram, above the equilibrium price. Then indicate the quantity demanded and the quantity supplied at the floor price. Then calculate the surplus (excess supply) that is created by imposing the floor price. E. g. The government decided to impose a minimum price of $5. The quantity demanded is now 1, 000 units and the quantity supplied is 1, 600 units, so the excess supply (surplus) is 600 units.

28. Calculate possible effects from the price floor diagram, including the resulting surplus, the change in consumer expenditure, the change in producer revenue, and government expenditure to purchase the surplus. Step 3 Calculate from the diagram the total amount that the government would have to pay to buy up the surplus. This would be the excess supply times the minimum price. E. g. The government would need to buy 600 units at $5 per unit = $3, 000. Step 4 Calculate the total income of the producers. This will come from sales to the consumers and sales to the government. E. g. The consumers will sell 1, 600 units at a price of $5 = $8, 000. They will receive $5, 000 from the consumers

Buffer stock scheme The prices of agricultural products such as wheat, cotton, cocoa, tea and coffee tend to fluctuate more than prices of manufactured products and services. This is largely due to the volatility in the market supply of agricultural products coupled with the fact that demand supply are price inelastic. One way to smooth out the fluctuations in prices is to operate price support schemes through the use of buffer stocks. But many of them have had a chequered history. Buffer stock schemes seek to stabilize the market price of agricultural products by buying up supplies of the product when harvests are plentiful and selling stocks of the product onto the market when supplies are low.

Buffer stock scheme A target price can be achieved through intervention buying and selling. The buffer stock managers are likely to establish a price ceiling, above which intervention selling will occur, and a price floor, below which intervention buying will take place.

Commodity agreements are arrangements between producing and consuming countries to stabilize markets and raise average prices. Such agreements are common in many markets, including the market for coffee, tea, and sugar. The market for commodities is particularly susceptible to sudden changes in conditions of supply conditions, called supply shocks. Shocks such as bad weather, disease, and natural disasters are largely unpredictable, and cause commodity markets to become highly volatile. In comparison, markets for the final products derived from these commodities are much more stable.

Commodity agreements often involve intervention schemes, such as buffer stocks, and usually only last for a few years, whereupon they are re-negotiated. They differ from cartels such as OPEC, largely because discussions and negotiations involve both producer and consumer countries, unlike cartels, which are established to protect the interest of producers only. Example - The International Cocoa Agreement