Transcript supply and demand

Roadmap:
In chapter 6, we used supply and demand tools to
determine price and quantity effects of an excise tax.
In chapter 7, we developed the tools of consumer
and producer surplus to measure welfare effects.
Now, in chapter 8, we apply the tools of consumer
and producer surplus to see how taxes affect welfare.
One important lesson from chapter 6:
It doesn’t matter who (buyer or seller) is required to
send tax payment to government.
The key is that a tax introduces a “wedge” between
buyers’ and sellers’ prices.
Consider the market for a good:
Before tax goes into effect, we have equilibrium: p*, Q*
The tax introduces a “tax wedge.”
($/unit)
tax wedge = t $/unit
Supply
pb
Buyers’ price
increases to pb.
Sellers’ price
decreases to ps.
p*
ps
Demand
Qt
Q*
(units/day)
Quantity
decreases to Qt.
The government collects tax revenue = t x Qt $/day.
Now let’s look at
the welfare effects
of the t $/unit tax.
($/unit)
pb
p*
The reduction in total
surplus that results from ps
the tax (C + E) is called
the tax’s
“deadweight loss.”
Supply
A
B
D
C
E
F
w/o tax
Cons. surplus
A+B+C
Prod. surplus
D+E+F
Tax rev.
0
Tot. surplus A + B + C + D + E + F
Demand
Qt
Q*
w. tax
A
F
B+D
A+B+D+F
(units/day)
change
- (B + C)
- (D + E)
+ (B + D)
- (C + E)
Why does the excise tax result in a deadweight loss?
The tax “blocks” trade of all units between Qt and Q*.
These are units for which the demand price (WTP for
the marginal buyer) exceeds the supply price
(opportunity cost for the marginal seller).
Each of these units could be traded (at some “split-thedifference” price) yielding gains for buyer and seller.
Because these units are not traded, some potential
surplus is lost.
Let’s look at an example with some numbers.
($/unit)
Equilibrium quantity
is 100 units/day but . .
Supply
2.00
1.75
1.25
1.00
Demand
60 80 100
(units/day)
. . . an excise tax of
1.00 $/unit reduces
quantity to 60 units/day.
Consider one of the
units for which trade is
“blocked” by the tax -the 80th, say.
For the 80th unit, demand price (WTP for marg. buyer) is $1.75 . .
. . . and supply price (opp. cost for marg. seller) is $1.25.
Without tax, mutually beneficial trade of this unit is possible.
With tax, the trade is “blocked,” and some potential surplus is lost.
Start with supply and demand again.
($/unit)
Supply
Demand
Consider tax wedges
of two different sizes.
A bigger tax wedge
means a bigger
deadweight loss.
(units/day)
In fact, the magnitude of the deadweight loss increases
faster than proportionately, as the tax wedge increases.
For a tax wedge of a given size, how is the size of
deadweight loss affected by supply elasticity?
($/unit)
($/unit)
S1
S2
Demand
Demand
(units/day)
(units/day)
A tax wedge . . .
. . . results in a deadweight loss.
Now consider exactly the same demand . . .
. . . but with a more elastic supply.
Exactly the same tax wedge . . .
. . . results in a bigger
deadweight loss.
For a given size of the tax wedge (that is, for a given
$/unit amount of the excise tax) and a given demand
elasticity . . .
. . . deadweight loss is greater the more elastic
is supply.
Likewise, for a given size of the tax wedge and a given
supply elasticity . . .
. . . deadweight loss is greater the more elastic
is demand.
(You do the graphs for that case.)
Total tax revenue and the dollar-per-unit size of
the excise tax.
S
S
S
D
D
D
With a “small” tax wedge . . . tax revenue is “small.”
With a bigger tax wedge . . . tax revenue is bigger.
With a still bigger tax wedge . . .
. . . tax revenue is “small” again.
Graphing tax revenue as a function of excise tax size:
tax revenue
($/month)
tax size ($/unit)
When the tax becomes sufficiently large, people
stop buying and selling the good completely.
Tax revenue goes to zero.
Application: Arthur Laffer, President Ronald Reagan,
federal income tax, and “supply-side economics”
(. . . also known as “Voodoo economics,”
according to 1980 presidential candidate,
George Bush.)
(http://pages.stern.nyu.edu/~nroubini/SUPPLY.HTM)
The federal income tax is, to a large extent, a tax on
labor.
It introduces a “tax wedge” between supply and
demand in the labor market.
In the context of the federal income tax, reinterpret
“tax size” as . . .
marginal tax rate: the extra taxes paid on an additional
dollar of income.
“Tax revenue” corresponds to the total amount collected
by the IRS in federal income tax.
For this application: A new version of the tax-revenue
vs. tax size graph, called the “Laffer curve.”
federal
income
tax
revenue
($/year)
In reality:
Laffer curve
Things aren’t
quite as simple as
this picture implies.
marginal income
tax rate (%)
-- there are lots of marginal tax rates (chpt. 12)
-- the precise shape and location of curve depends on
supply and demand elasticities in lots of labor markets.
But the general nature of the relationship does suggest
one very intriguing possibility:
income
tax rev.
($/year)
If our economy were
currently located to the
right of the Laffer curve’s
peak . . .
. . . then a decrease
in marginal tax rates . . .
marginal income
tax rate (%)
. . . would actually increase (!) federal income tax revenue.
How could this be?
With a decrease in marginal tax rates, workers would
keep more of every dollar earned.
This would induce them to supply more labor. (That’s
why it’s called “supply-side economics.”)
(http://en.wikipedia.org/wiki/Supply-side_economics)
More labor supplied, means more labor income, and
more dollars for the IRS to tax.
Even though each dollar of income is taxed at a lower
rate, there would be more tax revenue collected.
Sounds great! . . .
. . . in theory.
The critical question: Where is the economy located in
relation to the Laffer curve’s peak?
In the mid- to late-70s, Arthur Laffer said we were to
the right of the peak.
Most economists disagreed.
Ronald Reagan believed him.
President Reagan’s tax cuts led to significant decreases
in federal income tax revenue . . .
. . . and contributed to significant federal
government deficits throughout the Reagan
administration.
Experience shows that the economy actually was “to
the left” of the Laffer curve’s peak.
Where is Arthur Laffer today?
He’s all over the internet on “Speaker Bureau” websites.
“Dr. Laffer’s economic acumen and influence
in triggering a worldwide tax-cutting
movement have earned him the distinction
in many publications as “The Father of
Supply-Side Economics.”
(http://premierespeakers.com/815/index.cfm)
“Dr. Arthur Laffer, one of the most
distinguished economists of our time, was
named as one of the “55 People Who Most
Influenced Business in this Century” by
the Wall Street Journal.”
(http://eaglestalent.com/ . . .
Also: http://keynotespeakers.com/ . . .
Speaking fee:
$32,500 plus expenses