1.3. Government Intervention

Syllabus Content

• Indirect taxes - Specific (fixed amount) taxes and ad valorem (percentage) taxes and their impact on markets; tax incidence and price elasticity of demand and supply
• Subsidies - Impact on markets
• Price controls - Price ceilings (maximum prices): rationale, consequences and examples; Price floors (minimum prices): rationale, consequences and examples

Triple A Learning - Government Intervention

Triple A Learning - Government Intervention questions

Triple A Learning - Government Intervention simulations & activities

1.3. Government Intervention

Indirect Taxes

Indirect taxes are those imposed by a government on goods and services, in contrast to direct taxes, such as income and corporation tax, which are levied on incomes of households and firms. Indirect taxes are also called expenditure taxes.

The purpose of indirect taxes is to:

1. Generate tax revenue for a government

2. Discourage consumption of ‘harmful’ products

3. Encourage consumption of ‘good’ products

Specific and ad valorem taxes

There are two types of indirect tax; specific and ad valorem.

A unit tax is a set amount of tax per unit sold, such as a 10p tax on packets of cigarettes. In contrast, an ad valorem tax is a percentage tax based on the value added by the producer. Value Added Tax (VAT), currently at 20% in the UK, is the most important ad valorem tax. VAT was reduced to 15% in 2008 as part of the governments rescue package for the economy, but put back up to 17.5% in 2010. The basic rate was increased to 20% in 2011.

One advantage of ad valorem taxes is that the tax revenue to the government can rise automatically as the economy grows. This means that the tax rate does not need to be adjusted frequently, as in the case of specific unit taxes, such as duties on cigarettes and alcohol.

The imposition of either type of indirect tax has an effect similar to a rise in production costs. This means that a firm's supply curve will shift up vertically by the amount of the tax.

A specific unit tax

A specific unit tax will shift up the supply curve by the full amount of the tax, so that the new curve is parallel to the original one, as shown.

The incidence of a tax

The economic incidence, or burden, of a tax indicates the extent to which someone is made worse off by the tax. In contrast, the statutory incidence simply indicates who the law says will pay the tax. The economic and statutory incidence are often very different.

The effect of price elasticity of demand

In most cases, the burden is split between producers and consumers and both parties are worse off. The key to whether the consumer or producer carries the burden is the extent to which the tax can be passed on to the consumer in terms of higher prices.

Task 1: Questions on Taxation

1: The market for pizza is characterized by a downward-sloping curve and an upward-sloping supply.

(a) Draw the competitive market equilibrium. Label the price, quantity, consumer surplus and producer surplus. Is there any deadweight loss? Explain.

(b) Suppose that the government forces each pizzeria to pay a $1 tax on each pizza sold. Illustrate the effect of this tax on the pizza market, being sure to label the consumer surplus, producer surplus, govt revenue and deadweight loss. How does each area compare to the pre-tax case?

2: Consider the market for rubber bands.

(a) If this market has very elastic supply and very inelastic demand, how would the burden of a tax on rubber bands be shared between consumers and producers? Use the tools of consumer surplus and producer surplus in your answer.

(b) If this market has very inelastic supply and very elastic demand, how would the burden of a tax on rubber bands be shared between consumers and producers? Contrast your answer to part (a)

3: Suppose that the government imposes a tax on heating oil.

(a) Would the deadweight loss from this tax likely be greater in the first year after it is imposed or in the fifth year? Explain.

(b) Would the revenue collected from this tax likely be greater in the first year after it is imposed or in the fifth year? Explain

4: After economics class one day, your friend suggests that taxing food would be a good way to raise revenue because the demand for food is quite inelastic. In what sense is taxing food a “good” way to raise revenue? In what sense is it not a good way to raise revenue?

5: A senator in the US once introduced a legislative bill that would levy a 10,000% tax on hollow-tipped bullets.

(a) Do you expect that this tax would raise much revenue? Why or why not?

(b) Even if the tax would raise no revenue, what might be the senator’s reason for proposing it?

6: Suppose the government currently raises $100 million through a $0.01 tax on widgets, and another $100 million through a $0.10 tax on gadgets. If the government doubled the tax rate on widgets and eliminated a tax on gadgets, would it raise more money than today, less money or the same amount of money? Explain.

7: In the 1980s the British Government imposed a poll tax that required each person to pay a flat amount to the government independent of his or her income or wealth. What is the effect of such a tax on economic efficiency? What is the effect on economic equity? Do you think this was a popular tax?

8: Suppose the government requires beer drinkers to pay a €2 tax on each case of beer purchased. Currently, the price of a case of beer is $24.50

(a)Draw a supply and demand diagram of the market for beer without the tax. Show the price paid by consumers, the price received by producers and the quantity of beer sold. What is the difference between the price paid by consumers and the price received by producers?

(b)Now draw a supply-and-demand diagram for the beer market with the tax. Assume that the consumer burden is 75% and the producer burden is 25%. Show the price paid by consumers, the price received by producers and the quantity of beer sold. What is the difference between the price paid by consumers and the price received by producers? Has the quantity of beer sold increased or decreased?

9: Consider the following policies, each of which is aimed at reducing violent crime by reducing the use of guns. Illustrate each of these proposed policies using a demand and supply diagram for the gun market.

(a)A tax on gun sellers

(b) A price floor on guns

(c) A tax on ammunition

10: The US government administers two programs that affect the market for cigarettes. Media campaigns and labelling requirements are aimed at making the public aware of the dangers of cigarette smoking. At the same time, the Department of Agriculture maintains a price support program for tobacco farmers, which translates into an effective subsidy for tobacco growers.

(a)How do these two programs affect cigarette consumption? Use a graph of the cigarette market in your answer.

(b)What is the combined effect of these two programs on the price of cigarettes?

(c) Cigarettes are also heavily taxed. What effect does this tax have on cigarette consumption?

HL only: Linear demand and supply functions: calculating the effects of specific (excise) taxes on markets and community welfare

1: Suppose we are given the following demand and supply functions:

Qd = 60 – 2P

Qs = -4 + 2P

(a) Solve for the equilibrium price and quantity.

(b) Plot the two curves on a coordinate map.

Suppose the government imposes an indirect (excise) tax on the product of $6 per unit. This means that the supply curve will shift upwards by $6 for each level of output.

The new supply curve S2 (S1 + tax) lies above the initial supply curve S1. Just count $6 up along the vertical axis from the y-intercept of 2. We find that the new y-intercept of S2 is 8. Now draw a line parallel to S1 – this gives you the new supply curve.

2: How to find the new price paid by consumers, the price received by producers and the quantity bought and sold following the imposition of a tax.

To get accurate values, we must find the new post-tax supply function, solve for Pc and Qt and then use Pp = Pc – tax per unit to find Pp.

Given a supply function of the general form Qs = c + dP, whenever there is an upward shift of the function by t units, where t = tax per unit, we replace P by P –t. The new supply function becomes Qs = c + d (P – t)

We can now use this rule to find the new supply function. Our initial supply function was Qs = -4 + 2P. With a tax of $6 per unit, this function shifts upwards by $6, so that t =6. Therefore the new supply function becomes:

Qs = -4 + 2(P-6)

Simplify to find the new supply function.

Plot the new supply function on the diagram

3: Now use the original demand function and new supply function to solve for equilibrium price and quantity

Qd = 60 – 2P

Qs =

4: Using the data in the table below:

(a) Find the equations of the supply and demand curves and graph your results

(b) Now suppose that a $1 per unit sales tax is imposed. Find the S + T equation and determine how much equilibrium price rises. Graph your results

5: Impact of a Unit Sales Tax

Suppose that a $2 per unit sales tax is implemented (Column 4).

The firm, of course, will treat the tax as an additional cost and will try to pass it on to the buyer. Notice that with no tax (Column 3) the firm would offer 9 units at a price of $3. Once the tax is imposed, the firm will offer 9 units only at a price of $5.

(a) Calculate the original linear demand and supply functions. Plot these functions on a diagram

(b) Determine the equilibrium price and quantity. Verify that your calculations and positioning (diagram) are the same values.

(c) If a $2 specific tax is imposed on the product, determine the values for Column 4

(d) Using the values in Column 4 calculate the new linear supply function.

(e) Taking the original linear demand and the new linear supply function calculate the new equilibrium price and quantity.

(f) Plot the new linear supply function on the diagram

(g) Calculate the area of

· Tax revenue

· Consumer Surplus

· Producer Surplus

· Economic/Total/Community Surplus

Subsidies

A subsidy is an amount of money given directly to firms by the government to encourage production and consumption. A unit subsidy is a specific sum per unit produced, which is given to the producer.

The effect of a specific per unit subsidy is to shift the supply curve vertically downwards by the amount of the subsidy. In this case the new supply curve will be parallel to the original. Depending on elasticity of demand, the effect is to reduce price and increase output.

The incidence of a subsidy

The economic incidence of a subsidy indicates who is made better off by the subsidy. In contrast, the legal incidence indicates who, by law, the subsidy is intended to help. In the diagram below, the subsidy per unit is A – B, and the new quantity consumed is Q1.

However, the price the consumer pays does not fall by the full amount of the subsidy – instead it falls from P to P1. Hence, although the intention of the subsidy may be to reduce the price to the consumer by the full amount of the subsidy, the producer gets some of the benefit in terms of extra revenue that they can keep. The gain to the consumer is P - P1 per unit, and the whole gain to the consumer is the area PFBP1.

The gain to the producer is C – P per unit and the total gain to the producer is CAFP. The overall cost of the subsidy to the government is the area, CABP1.

Questions on Subsidies

1: Suppose that the government subsidizes a good: For each unit of the good sold, the government pays $2 to the buyer. How does the subsidy affect consumer surplus, producer surplus, tax revenue and total surplus? Does a subsidy lead to a deadweight loss? Explain

2: A subsidy is the opposite of a tax. With a €0.50 tax on the buyers of ice-cream cones, the government collects €0.50 for each cone purchased; with a €0.50 subsidy for the buyers of ice-cream cones, the government pays sellers €0.50 for each cone sold.

(a)Show the effect of a €0.50 per cone subsidy on the market for ice-cream cones.

(b) Do consumers gain or lose from this policy? Do producers gain or lose? Does the government gain or lose?

Linear demand and supply functions: calculating the effects of subsidies on markets and community welfare

1: Suppose we are given the following demand and supply functions:

Qd = 60 – 2P

Qs = -20+ 2P

(a) Solve for the equilibrium price and quantity.

(b) Plot the two curves on a coordinate map.

Suppose the government grants a subsidy of $4 per unit. This means that the supply curve will shift downwards by $4 for each level of output.

The new supply curve S2 (S1 - subsidy) lies below the initial supply curve S1. Just count $4 down along the vertical axis from the y-intercept of 10. We find that the y-intercept of S2 is 6. Now draw a line parallel to S1 – this gives you the new supply curve.

2: How to find the new price paid by consumers, the price received by producers and the quantity bought and sold following the granting of a subsidy. To get accurate values, we must find the new post-subsidy supply function, solve for Pc and Qsub and then use Pp = Pc + subsidy per unit to find Pp.

Given a supply function of the general form Qs = c + dP, whenever there is an downward shift of the function by s units, where s = subsidy per unit, we replace P by P + s. The new supply function becomes Qs = c + d (P +s)

We can now use this rule to find the new supply function. Our initial supply function was Qs = -20 + 2P. With a subsidy of $4 per unit, this function shifts downwards by $4, so that s = 4. Therefore the new supply function becomes:

Qs = -20 + 2(P + 4)

· Simplify to find the new supply function.

· Plot the new supply function on the diagram

3: Now use the original demand function and new supply function to solve for equilibrium price and quantity

Qd = 60 – 2P

Qs =

4: The following question comes from the website http://www.econclassroom.com/wp-content/uploads/2011/11/GovernmentInterventionPractice-Calculatingtheeffectsofsubsidies.pdf [accessed November 29 2014]

Assume the supply and demand for petrol in China is represented by the following equations:

● Qs = -200 + 100P

● Qd = 1,000 - 200P

where Qs is the quantity supplied (in millions of litres) by Chinese petrol firms and Qd is the quantity demanded (in millions of litres) by Chinese petrol consumers. P is the price per litre for petrol expressed in Chinese yuan.

a) Illustrate the market for petrol in China in equilibrium assuming no government intervention.

b) Calculate the equilibrium price and quantity of petrol in China, and label them on your graph.

c) Calculate the amount of consumer and producer surplus in the Chinese petrol market. Add these together to determine the amount of total welfare (economic surplus) in the petrol market.

d) Assume that the government wishes to make petrol more affordable to Chinese consumes, so it provide a 1 yuan subsidy per litre for petrol producers. Derive the new supply equation for petrol in China.

e) Plot the original supply and demand curves, then show the effect of the 1 yuan subsidy for petrol producers.

f) Calculate the new equilibrium price consumers will pay for petrol and the new equilibrium quantity of petrol produced. Calculate the price that petrol producers will receive following the 1 yuan subsidy. Indicate these on your graph.

g) Calculate each of the following:

a. the new area of consumer surplus that will result from the petrol subsidy.

b. the new area of producer surplus following the subsidy.

c. The net increase in consumer and producer surplus resulting from the subsidy.

(h) Calculate the cost the subsidy imposes on taxpayers in China.

(I) Compare the cost you calculated in number 8 to the net increase in consumer and producer surplus you calculated in 7,c). What does the difference between these two figures represent?

(j) On the graph you drew in #5, shade and label the area that represents the net effect on total welfare (economic surplus) of the subsidy. Does this represent an increase or a decrease in overall efficiency in the petrol market? Explain.

Price Ceilings/maximum price & Price Floors/minimum price

In the real world, market price might not be allowed to find its own level, and markets might not clear efficiently. The prices of many goods, services, and resources in the real world might be kept artificially low or high by private firms, or by governments, for a number of reasons.

Price ceilings

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. For example, it is customary in London to make public transport free late on New Year’s Eve to enable revellers to get home safely.

UK Premiership football clubs also limit the price of their tickets to levels well below the natural market rate for three main reasons. Firstly, football is the UK’s national winter sport and, historically, ticket prices have been affordable for those on average incomes. Secondly, a large share of club income is generated from the sale of broadcasting rights to TV companies, and this supplements revenue from ticket sales, as does revenue from merchandising and sponsorship. Thirdly, there would be considerable political uproar if ticket prices were not held down below market price.

Demand for tickets outstrips supply at the artificially low price.

Non-market allocation of resources

In the case of a football club like Manchester United, fixing artificially low ticket prices means that the relative shortage of tickets must be dealt with in non-price ways. Football clubs may use all, or some of the following methods:

1. Arranging a ballot for ticket allocations.

2. Implementing a first come first served queuing system.

3. Sale of tickets through supporters clubs.

4. Setting up a ticket exchange scheme, as in the case of Manchester United’s One United system.

5. Bundling low priced tickets with an exclusive hospitality ticket.

Parallel or black markets may emerge to satisfy the excess demand, with ticket touts paying more than the face value of the ticket, and then selling them to other buyers at even higher prices.

Price floors

Price may also be set above the natural market price. 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 labour 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.

Price floors

If a price floor is set for rice, there would be an excess of supply over demand. When price floors are set above the natural market clearing price, suppliers are encouraged to over-supply, but consumers are discouraged from consumption.

Questions on Price Controls

1: Lovers of classical music in Austria persuade their Parliament to impose a price ceiling of €40 per ticket for music concerts. Does this policy get more or fewer people to attend classical music concerts?

2: The government has decided that the free market price of cheese is too low.

(a)Suppose the government imposes a binding price floor in the cheese market. Use a demand and supply diagram to show the effect of this policy on the price of cheese and the quantity of cheese sold. Is there a shortage or surplus of cheese?

(b) Farmers complain that the price floor has reduced their total revenue. Is this possible? Explain

(c) In response to farmers’ complaints, the government agrees to purchase all of the surplus cheese at the price floor. Compared to the basic price floor, who benefits from this new policy? Who loses?

3: A recent study found that the demand and supply schedules for Frisbees are as follows:

(a)What is the equilibrium price and quantity of Frisbees

(b)Frisbee manufacturers persuade the government that Frisbee production improves scientists’ understanding of aerodynamics and thus is important for national security. A concerned parliament votes to impose a price floor €2 above the equilibrium price. What is the new market price? How many Frisbees are sold? Graph this information

(c) Irate college students march on Parliament and demand a reduction in the price of Frisbees. An even more concerned Parliament votes to repeal the price floor and impose a price ceiling €1 below the former price floor. What is the new market price? How many Frisbees are sold? Graph this information.

4: Consider the market for labour and the existence of a minimum wage.

(a)Suppose the minimum wage is above the equilibrium wage in the market for unskilled labour. Using a demand-and-supply diagram of the market for unskilled labour; show the market wage, the number of workers who are employed and the number of workers who are unemployed.

(b) Now suppose the Minister for Labour proposes an increase in the minimum wage. What effect would this increase have on employment/ Does the change in employment depend on the elasticity of demand, the elasticity of supply, both elasticities, or neither?

(c) If the demand for unskilled labour were inelastic, would the proposed increase in the minimum wage raise or lower total wage payments to unskilled workers? Would your answer change f the demand for unskilled labour were elastic?

5: The table below shows the demand and supply schedules for rental apartments in a Chicago suburb of the United States.

(a) What is the rent in this suburb and how many apartments are rented?

(b) If the city of Chicago imposes a rent ceiling of $900 a month, what is the rent in this suburb and how many apartments are rented?

(c) If the city of Chicago imposes a rent ceiling of $600 a month, what is the rent in this suburb and how many apartments are rented?

(d) With a strictly enforced $600 rent ceiling, is the housing market efficient? Why or why not?

(e) If the city strictly enforces the rent ceiling, is the housing market fair? Explain why or why not.

(f) If a parallel market develops, how high could the parallel market rent be? Explain your answer.

6: The table below shows the demand and supply schedules for tomato pickers in southern California.

(a) What is the equilibrium wage rate of tomato pickers and what is the equilibrium quantity of tomato pickers employed?

(b) Is the market for tomato pickers efficient?

(c) If California introduces a minimum wage for tomato pickers of $4 an hour, how many tomato pickers are employed and how many are unemployed?

(d) If California introduces a minimum wage for tomato pickers of $8 an hour, how many tomato pickers are employed and how many are unemployed?

(e) Is the minimum wage of $8 an hour efficient? Is it fair?

(f) Who gains and who loses from the minimum wage of $8 an hour?

7: During the 1996 Olympic Games, many residents of Atlanta left the city and rented out their homes. Despite the increase in the quantity of housing available, rents soared. If the city of Atlanta had imposed a rent ceiling at the time of the 1996 Olympic Games, describe how the housing market would have functioned.

8: Concerned about the political fallout from rising fuel prices, the government decides to impose a ceiling on the price of petrol of $1.00 a litre. Explain how the market for petrol would react to this price ceiling if;

(a) The oil-producing nations increased production and drove the equilibrium price of petrol to 90 cents a litre.

(b) A global shortage of oil sent the equilibrium price of petrol to $2.00 a litre.

9: Bakers earn $10 an hour, petrol pump attendants earn $4 an hour, and copy shop workers earn $5 an hour. If the government introduces a minimum wage of $5 an hour, explain how the markets for bakers, petrol pump attendants and copy shop workers will respond initially to the minimum wage.

10: The equilibrium retail price of beef falls to $2 a kilo, a price at which cattle ranchers cannot survive. To help the struggling ranchers, the government declares that it is illegal to buy beef for less than $5 a kilo. The government also appoints a large number of observers to keep a close watch on the beef market and ensure that the law is observed to the letter. Parallel market traders are effectively eliminated. Describe the situation in the beef market, and explain why the cattle ranchers want the government to abandon the price floor.

HL only - Linear equations and Price Controls

Price Ceiling/Maximum Price

1. Calculate possible effects from the price ceiling (maximum price) diagram, including the resulting shortage, change in expenditure and total expenditure.

The linear demand and liner supply equations are:

Qd = 2000 – 200P

Qs = -400 + 400P

(a) On a graph, draw the two linear equations and find the resulting equilibrium price and equilibrium quantity values

(b) The government decides to impose a maximum price (price ceiling) of $3 on this product. Graph this on your diagram

(c) Calculate the QD and QS values at the maximum price of $3. Identify the effect on the market following the imposition of the maximum price

(d) Calculate the total revenue earned by the producer before and after the imposition of the maximum price

(e) Suppose that producers and some consumers complain about the maximum price. In response the government decides to allocate a subsidy to producers to eliminate the market disequilibrium. Thus the linear supply function must change in line with the new level of supply required. Calculate the new linear supply function.

(f) At this new equilibrium price and quantity, calculate the level of subsidy per unit and total subsidy payment that the government would have to allocate to producers.

2: In the market for beef, the demand function is QD = 800 – 100P and the supply function is QS = 150P, where price is given in $ per kilo and quantity is given in thousands of kilos per month. The government then imposes a maximum price of $2 per kilo in order to protect consumers.

i. On a graph, draw the original demand and supply curves and indicate equilibrium.

ii. On the same graph, show the maximum price and indicate the quantities demanded and supplied at that price.

iii. From the graph, calculate the excess demand created.

iv. From the graph, calculate the change in consumer expenditure/producer revenue.

v. Give the supply function, following a subsidy, which would eliminate the excess demand.

vi. Draw the new supply curve on the graph and calculate the necessary subsidy per unit that the government would have to pay in order to eliminate the excess demand.

vii. Calculate the total subsidy payment that the government would have to make.

viii. Not using the graph, calculate the shortage at the maximum price. [Extra credit]

ix. Not using the graph, calculate the amount of the subsidy necessary to eliminate the shortage. [Extra credit]

Price floors/minimum prices

1: Calculate possible effects from the price floor (minimum price) diagram, including the resulting surplus, change in expenditure and total expenditure.

The linear demand and liner supply equations are:

Qd = 2000 – 200P

Qs = -400 + 400P

(a) The government decides to impose a minimum price (price floor) of $5 on this product. Graph this on your diagram

(b) Calculate the QD and QS values at the minimum price of $5. Identify the effect on the market following the imposition of the minimum price

(c) Calculate from the diagram the total amount that the government would have to pay to buy up the surplus.

(d) Calculate the total income of the producers (market + government intervention)

2: In the market for beef, the demand function is QD = 800 – 100P and the supply function is QS = 150P, where price is given in $ per kilo and quantity is given in thousands of kilos per month. The government then imposes a minimum price of $4 per kilo in order to protect the farmers.

i. On a graph, draw the original demand and supply curves and indicate equilibrium.

ii. On the graph, show the minimum price and indicate the quantities demanded and supplied at that price.

iii. From the graph, calculate the excess supply created.

iv. Calculate the amount the government will have to pay to buy up the surplus.

v. Calculate the total revenue received by the farmers, if the government buys up the surplus.

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