Econ 201

Government Policy &

Economic Welfare

Summary of All Policies

Evaluating the Impact of Government Intervention

• Policy Instruments Available– Taxes

• Typically: per-unit tax on output• Others: lump-sum, value added (VAT)

– Subsidies• Rebate on per-unit produced

– Price Floors• Minimum price that can be charged (e.g., minimum wage)

– Price Ceilings• Limit on the maximum price that can be charged (WIN)

– Quotas• Limits on amounts produced/imported • Infant industry/protectionism

Key Assumptions

• No Market Failure– No externalities

• i.e., benefits or costs that are not accounted for in the marketplace (e.g., no free riders, no pollution costs that aren’t captured in the product’s price)

– Perfectly competitive markets• Large # of suppliers and buyers

• Evaluate Market Efficiency– Look at losses/gains in consumer/producer

surplus

Effect of a Tax on the Supply Curve

• To the supplier: increases per-unit costs– Shifts supply curve to the left

• Reduces amount supplied and raises the market clearing price

• How do we measure the effects of the tax?– Efficiency or deadweight losses are losses in

consumer and producer surplus relative to the “ideal” market

How Do We Analyze the Effects of Taxes and Subsidies

• The efficient ideal market– “perfectly competitive” market

• Consumers and suppliers are price-takers, i.e. have no market power

Effect of a Tax on the Supply Curve

Deadweight Loss

How Do We Evaluate the Impact of the Tax?

• Two Parts:– Tax Incidence

• Who pays for it more? – Consumers or Producers?– Will depend on relative demand/supply elasticities

– Economic welfare analysis• Does the tax (revenue) improve social welfare?

– Will depend on relative elasticities of:» a) good taxed» B) good or program financed by the tax

Tax Incidence

• Essential question is: how much of the tax can be passed on to consumers?– Suppliers will be able to a higher proportion of

the tax onto consumers when• Demand is relatively inelastic• Supply is relatively elastic

– Under these conditions• Consumer surplus losses >> producer surplus

losses

Economic Welfare Analysis

• Framework for analysis is comparing benefits and costs– Costs of the tax

• Reduction in equilibrium quantity • Increase in price paid

– Costs can be calculated as the deadweight loss in $ if demand and supply curves are known

What Are the Benefits?

• Depends on what we do with the tax revenues• Suppose we use it to subsidize another good

• Subsidy appears as a reduction in per-unit costs to the firm getting the subsidy

Figure A-1. The Deadweight Loss from a Price Subsidy

SOURCE: Congressional Budget Office.

Evaluating The Impact

• Costs:– Deadweight loss: sum of reduction in consumer and

producer surplus for the taxed good• Reflects reduction in Qd and higher price paid

• Benefits– Gain in CS and PS from subsidized cost

• Will Benefits > Tax?– Depends on the relative demand elasticities for the 2

goods

Evaluating the Impact

• “A Positive Analysis” (Distributional Consequences)– Who gains/loses from the tax and subsidy?– Both producers and consumers of the taxed

good lose (in terms of lost surpluses)– Relative demand/elasticities determine who loses more

» More inelastic demand -> greater is CS loss

– Producers and Consumers of subsidized good win (lower price and more Q)

– Relative demand supply elasticities determine who benefits most

Total Social Welfare

• Ideally the impact of a program should be evaluated as: {Pareto efficient}

– 1) can at least one person’s welfare be improved– 2) without making anyone worse off– http://en.wikipedia.org/wiki/Pareto_efficiency

• More realistically: Could the winners compensate the losers? {Pigouvian}

– Is the deadweight loss of the taxed good less than the surplus gain from the subsidized good?

– http://en.wikipedia.org/wiki/Pigovian_tax

So Do They Do This in the Real World?

• The Senate has approved a bill that would require gasoline producers to blend 36 billion gallons of ethanol into gasoline by 2022, an increase from the current standard of 7.5 billion gallons by 2012. The House did not include such a provision in the version it passed, and it is uncertain whether any final legislation will emerge this year and what it will say about ethanol if it does.

• What would be the impact of such legislation on the demand for ethanol? For corn-based food prices?

Price Floors

• A price floor is a government or group imposed limit on

how low a price can be charged for a product. – For a price floor to be effective, it must be greater than the

equilibrium price.

Examples of Price Floors

• Minimum wage– Can create a surplus of labor

• Agricultural price supports– Every year, farmers produce and sell a certain product at a

certain price that is determined by the market. If the market price is lower than that price at which the farmers want to sell, the farmers are in a deficit. Therefore, in order to assist American farmers, our government gives price supports for some crops and dairy products. So in a case where the market price is lower that the target price for farmers, farmers receive a "deficiency payment", or price support, from the government in order to make up for the difference.

– Has created a surplus of cheese and milk products• Some released to low-income/poverty households• Can exacerbate the effect by increasing supply

An Economist’s Perspective

• Cato Institute – http://www.cato.org/pubs/tbb/tbb_0707_47.pdf

• The federal government has subsidized and regulated the dairy industry since the 1930s. A system of “marketing order” regulations was enacted in 1937. A dairy price support program was added in 1949. An income support program for dairy farmers was added in 2002.

• As part of this year’s farm bill, Congress may reauthorize dairy programs, but they are among the most illogical of all farm programs.1 The government spends billions of dollars reducing food costs through programs such as food stamps, yet dairy programs increase milk prices.

Price Ceilings

• A price ceiling is a government-imposed limit on how high a price can be charged on a product. For a price ceiling to be effective, it must differ from the free market price – Example:

• New York City rent control– Landlords are not allowed to raise rental prices

• Gerald Ford’s Whip Inflation Now (WIN)• World War II

– Somewhat effective (resulted in blackmarkets, rationing)

– Impact:• Shortages and higher costs

Welfare Effects of Rationing

Quotas

• A restriction of limit on:– The number of migrant workers that can be

legally employed in the US– The amount of a good or resource that can be

imported to the US, or exported from the US– The amount of a resource that can be

“harvested” during a period of time (e.g., fish or mining)

– The amount of a pollutant that can be emitted– The number of taxi cabs that can be licensed

Trade Quotas• Import quotas are limitations on the quantity of goods that can be imported

into the country during a specified period of time. An import quota is typically set below the free trade level of imports. In this case it is called a binding quota. If a quota is set at or above the free trade level of imports then it is referred to as a non-binding quota. Goods that are illegal within a country effectively have a quota set equal to zero. Thus many countries have a zero quota on narcotics and other illicit drugs.

• There are two basic types of quotas: absolute quotas and tariff-rate quotas. Absolute quotas limit the quantity of imports to a specified level during a specified period of time. Sometimes these quotas are set globally and thus affect all imports while sometimes they are set only against specified countries. Absolute quotas are generally administered on a first-come first-served basis. For this reason, many quotas are filled shortly after the opening of the quota period. Tariff-rate quotas allow a specified quantity of goods to be imported at a reduced tariff rate during the specified quota period.

• In the US in 1996, milk, cream, brooms, ethyl alcohol, anchovies, tuna, olives and durum wheat were subject to tariff-rate quotas. Other quotas exist on peanuts, cotton, sugar and syrup.

Useful Websites• http://www.sjsu.edu/faculty/watkins/taximpact.html•

• Economic Welfare Analysis • Price Controls• Monopoly• Monopsony• Taxes and Subsidies• Oligopoly• Marginal Cost Pricing• Price Discrimination• Trade • Externality Tax 

Weekend’s Problem

• # 1: Congress is currently considering an energy bill which would mandate that all gasoline producers use include at least 10% ethanol in each gallon of gas– 1. What would be the impact of this on the gasoline

market?– 2. What would be the impact of this on the ethanol

market?– 3. Impact on the corn market (for both food and

gasoline)?– 4. Impact on the food products containing corn

market?

Weekend’s Problem

• #2 The US provides price supports (minimum price) to the producers of milk. – Assuming that the support is effective, what would be

the economic welfare impact on the milk market?– The US government also provides food stamps to

subsidize food purchases. What is the impact of the food stamp program (alone) on economic welfare?

– What can you say about the combined impact of both the price support and food stamp programs on economic welfare?