Sunday, September 14, 2014

Government Intervention 1 - Indirect Taxes

Government Intervention

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Includes all of the following:
  • Indirect Taxes
  • Subsidies
  • Price Floors
  • Price Ceilings
  • What I like to call (world price)
Nixon imposes wage and price controls - 1971

Venezuelan President Nicolas Maduro, furthers Price Controls, 2013

Venezuela used cars. Price Controls

Indirect Taxes

Indirect taxes  - are taxes on the expenditure of goods and services. It increases the cost of production and shifts the supply curve to the left.

The vertical distance between the old and new supply curve is the size (amount) of the tax.
Governments impose indirect taxes for several reasons:
  • to finance government expenditures (raise revenue)
  • discourage socially undesirable activities (raises the taxes on gas to discourage driving)
  • promote economic growth (imposes tariffs to lower consumption of imported goods)
  • reduce inequality
Two types of Indirect taxes:
  • specific
  • ad valorem
Specific Tax - a tax on a good that is set as a fixed amount per UNIT.
                         ex. the government imposes a two dollar a pack cigarette tax.

Ad Valorem Tax - an indirect tax expressed as a percentage of the price of the product.
                                ex. VAT taxes - Value Added Tax - the government enforces a 20% tax on the                                             expenditure.

The best way to learn how to do tax intervention, cause and effect is to do an AP tax problem. Look closely at the graph and what is asked for in the question. The same structure is used for many of the Gov't intervention FRQ's.

1995 AP Microeconomics Exam - FRQ, #2

2) The graph above shows the market for a good that is subject to a per-unit tax

      (a) Using the labeling on the graph, identify each of the following:

  • The equilibrium price and quantity before the tax.
This is easy in that we just need to look at the original supply curve and trace the equilibrium price (12) and the equilibrium quantity (100).          
  • The  area representing the consumer surplus before the tax.  
Did you see the before the tax,,, Important, right! The consumer surplus before the tax is the sum of the A+B+C+F, area. 
  • The area representing the producer surplus before the tax.
I know you saw the before the tax this time,,, failure to read the question closely is a big problem with answering these questions correctly. The producer surplus before the tax is D+G+E, area or 100$.

(b) Assume that the tax is now imposed. Based on the graph, does the price paid         by the buyers rise by the full amount of the tax? Explain.

If we look at the old equilibrium price of ($12) and the after the tax, new equilibrium price of ($13) we can say that the price paid by consumers increased by $1 after the tax. But the question asks, does the price paid by the buyer rise by the full amount of the tax, since the tax is $2 per unit and the consumer only paid $1 of the tax,, the consumer in fact, did not pay the full amount of the tax.

Explain, why? - Remember that the vertical distance between the two parallel supply curves is equal, up and down the curves. With that in mind, look at the vertical line running down from the new, taxed, equilibrium to the new quantity of 80 units. Look at the original supply curve and recognize that if the distance between old and new supply curve is the amount of the tax,, then we can see that the tax increased the cost of the good by $2 from $11 to ($13 the new equilibrium amount). Draw a line straight down through the new (taxed) supply equilibrium and where it crosses the old supply curve will show you the amount of the tax.  

That's a lot of words. :0

OK, so we can see that the tax was $2 and the consumer paid only $1 of the tax,,, why??

Answer - The price paid by the buyer does not rise by the full amount,, and since supply and demand have the same elasticities both pay half. The more elastic the demand curve (flat) the more producers will bear the tax burden,,, the more elastic the supply curve the (flat) the more consumers will  bear the tax burden.

Nice graphic example:


(C) Using the labeling on the graph, identify each of the following after the                     imposition of the tax.

  • The net price received by the sellers.
Net price received by seller is $11 (net is what the seller actually puts in his pocket) after he pays his $1 to the government and the consumer pays his $1 to the government.
  • The amount of tax revenue.
 Tax revenue (money collected by the government from the tax)  is the areas B+C+D or $160.
The revenue is the $2 per unit tax times the number of units sold = 80,, so 2*80 = 160.
  • The area representing the consumer surplus.
Consumer surplus is A.
  • The area representing deadweight loss.
Deadweight loss is what has been lost by society due to the higher prices,,, they are looking for either an area or a quantity. The area of DWL (dead weight loss) is F+G. The quantity is 20 units.

Pajholden on Indirect Taxes - 

Welker on Indirect taxes - Elastic

Welker Indirect (excise) tax - Inelastic

1995 AP Microeconomics Exam

Answer - (D) The supply curve will shift to the left.

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