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Economic Efficiency, Government Price Setting, and Taxes

by: Caitrín Hall

Economic Efficiency, Government Price Setting, and Taxes ARE 1150

Marketplace > University of Connecticut > Agricultural & Resource Econ > ARE 1150 > Economic Efficiency Government Price Setting and Taxes
Caitrín Hall
GPA 3.9

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About this Document

These notes cover chapter 4 of the textbook.
Principles of Agriculture & Resource Economics
Emma Bojinova
Class Notes
Economics, Microeconomics, outline
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This 5 page Class Notes was uploaded by Caitrín Hall on Friday April 1, 2016. The Class Notes belongs to ARE 1150 at University of Connecticut taught by Emma Bojinova in Spring 2016. Since its upload, it has received 19 views. For similar materials see Principles of Agriculture & Resource Economics in Agricultural & Resource Econ at University of Connecticut.

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Date Created: 04/01/16
Chapter 4 Economic Efficiency, Government Price Setting, and Taxes  The invisible hand operates without interference; market continually adjusts to eliminate shortages and surpluses  The invisible foot (government) changes the natural market process to achieve a certain outcome  Price ceiling – a legally determined max price that sellers may charge  Price floor – a legally determined minimum price that sellers may receive o When gov’t imposes a price ceiling/floor, economic surplus is reduced 4.1 Consumer Surplus and Producer Surplus  Consumer surplus – the difference between the highest price a consumer is willing to pay for a good or service and the price the consumer actually pays  Marginal benefit – additional benefit to a consumer from consuming one more unit of a good/service  Marginal cost – additional cost to a firm of producing one more unit of a good  Producer surplus – the difference between the lowest price a firm would be willing to accept for a good/service and the price it actually receives Graphing  Demand curve – shows the marginal benefit consumers receive  Area below the demand curve and above price line represents the difference between the price consumers would have paid versus the price they did pay  Total amount of consumer surplus = area below the demand curve & above the market price  Total amount of producer surplus = area above the demand curve & below the market price What Consumer Surplus and Producer Surplus Measure  Consumer surplus measures net benefit to consumers o Total benefit minus total amount paid  Producer surplus measure net benefit received by producers o Total amount firms receive from consumers minus cost of production 4.2 The Efficiency of Competitive Markets  Equilibrium (EQ) results in the economically efficient level of output; MB = MC  Economic surplus – the sum of consumer and producer surplus o EQ in a competitive market results in the greatest amount of economic surplus (total net benefit to society)  Economic efficiency – a market outcome in which MB to consumers of the last unit produced = MC of production in which the sum of consumer surplus and producer surplus is at a maximum o Economic surplus is maximized when a market is in competitive EQ o Deadweight loss – reduction in economic surplus resulting from a market not being in competitive EQ; always graphed as a triangle 4.3 Government Intervention in the Market: Price Floors and Price Ceilings Price Floors: Government Policy in Agricultural Markets  Legally determined minimum price that buyers should pay for a good E  Binding – price floor is above P ; keeps price from reaching EQ price level  Price floor  consumer surplus declines  deadweight loss represents decline in economic efficiency o Government essentially buys the deadweight loss Price Ceilings: Government Rent Control Policy in Housing Markets  Binding if set below EQ level  Create shortages in the market  Rent controls o What are they? Price ceilings on rent set by the government o Why do we have them? To support families whose wage earners were fighting in WWI and WWII o Where do we have them? Some American cities and other big cities throughout the world (NYC, San Francisco, Los Angeles, etc.)  Impacts of binding rent controls o Shortages – excess demand o Black markets – markets in which buying and selling takes place at prices that violate government price regulations; tenants are worse off, while landlords are better off because BM price > price ceiling cost o Entrance fees (“key money”) o Higher search costs o Declines in the quality and maintenance of rental housing o Large, deserted apartment complexes in inner cities o Future supply will decline Results of Government Price Controls: Winners, Losers, and Inefficiency  Positive and Normative Analysis of Price Ceilings and Price Floors o Economists know the role competitive markets play in raising the average person’s standard of living and that too much gov’t intervention can reduce the ability of the market to produce increases in living standards in the future o Discussion of economic results is positive analysis; discussion of whether the results are desirable or not is normative analysis 4.4 The Economic Impact of Taxes  Sales tax – tax on tangible goods (most food is exempt)  Inheritance tax – tax on assets passed through inheritance  Property tax – tax on houses and land  Income tax – tax on earned income o State Income Tax Brackets Married, Filing Separately CT Taxable income $100,000-$200,000 – 6% $200,000-$250,000 – 6.5% $250,000 + – 6.95%  Excise tax – tax on a specific item – luxury tax, tariff (tax on imported goods), etc.  Social security tax – tax from income to pay for social security—half paid by employee and half by employer (theoretically); consumers usually pay more Why Tax?  To generate revenue for gov’t  Protectionist trade policy (tariff)  To alter a behavior or activity that generates negative externalities The Costs of Taxation  Tax revenue to gov’t  Administrative costs  Loss of consumer and producer surplus (deadweight loss) Two Principles of Taxation  A. The Benefit Principle o The individuals who receive the benefit of a good or service should pay the tax necessary to supply that good o Ex: gasoline taxes for road improvements and construction  B. The Ability-to-Pay Principle o Individuals who are most able to bear the burden of the tax should pay it o Ed: Progressive Income Tax  Progressive tax – takes larger share on income of high-income taxpayers than of low-income taxpayers  Regressive tax – takes smaller share of income of high-income taxpayers than of low-income taxpayers (ex: social security)  Supply curve shifts upward by the demand of the tax  Burden to consumers = change in prices  Burden to producers = tax – change in prices  Government tax revenue = tax x new quantity sold  Some consumer surplus and some producer surplus will become tax revenue for the government; some will become deadweight loss  Tax incidence – the actual division of the burden of a tax between the buyers and sellers in a market Determining Tax Incidence on a Demand and Supply Graph Does It Make a Difference Whether the Government Collects a Tax from Buyers or Sellers?  The burden of the tax remains the same whether it is paid mostly by producers or mostly by consumers Is the Burden of the Social Security Tax Really Shared Equally Between Workers and Firms?  Result when employers pay tax: demand for labor decreases  Result when workers pay tax: supply of labor increases  The burden of the tax falls almost entirely on workers in both panels Elasticity & Taxes  Elastic supply (flatter supply curve)  burden on consumers > burden on producers  Inelastic supply (steeper supply curve)  burden on producers > burden on consumers  Perfectly elastic demand curve  horizontal demand curve  burden of tax falls completely on producers  Perfectly inelastic demand  vertical demand curve  burden of tax falls completely on consumers  When comparing producers (suppliers) and consumers (demanders), whoever’s curve is flatter (more elastic) bears less of the burden of the tax


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