Microeconomics
1
Government Prices and Markets: Block 2
4.1. Government 4.2. Taxes 4.3. Subsidies 4.4. Price Controls
Lecture 4 Market Intervention
4.1.1. Government
Definitions: Regulation refers to government intervention to influence the allocation of resources by other economic agents, such as the quantity, price or characteristics of a good or service. Direct regulation (command-and-control) refers to direct actions (e.g. price controls, provision of goods and services). Indirect regulation (market-based) provides positive or negative incentives (taxes, subsidies) or information to private economic agents (households and firms).
• Production of goods and services • Purchase of goods and services • Redistribution of resources • Regulation
Government comprises public institutions at the national, regional and local level that have legitimacy and the right to compel other economic agents. The free market has no government other than the enforcement of property rights. If it is efficient then no government intervention is needed. For economists, government exists because markets sometimes fail to be efficient. Government provides the legal framework for economic activity (e.g. property rights, laws and standards). Government intervenes in the economy as an economic agent in four main ways:
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4.1.2. Inequality
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Definition: Economic inequality is how unequal national wealth is distributed or the difference in income or wealth between different individuals in an economy. Australia
% o
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0 10 20 30 40 50 60 70
is owned by the
top 20% 20-40 40-60 60-80 lowest 20%
Gini Coefficient for selected Countries
Brazil
% o
f w ea
lth
0 10 20 30 40 50 60 70
is owned by the
top 20% 20-40 40-60 60-80 lowest 20%
Nations with high levels of income inequality are associated with social ills including low life expectance, mental and physical health, social mobility, educational performance, high teenage pregnancy, homicide, imprisonment.
Wilkinson and Pickett, The Spirit Level: Why equality is better for everyone
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Taxes fulfil four main functions: (1) Raising revenue to produce and purchase (2) Correcting market failures (3) Redistributing resources (4) Financing government operations
Definitions: Tax is a payment to government, from buyers or sellers, for each unit of good that is bought or sold. Tax incidence is the burden of taxation, the degree to which buyers and sellers will be worse off due to the tax.
4.2. Taxes
Singapore Government Tax Revenue (2018)
Singapore Government Spending (2018)
The State of Tax Justice 2020 Report
Reasons for not paying full taxes
(1) Tax resistance: Opposition to government, tax legitimacy or how taxes are used (2) Low deterrence: Benefit of evasion vs. cost of penalties (3) Tax complexity and compliance cost
Definitions: Tax evasion means illegally misrepresenting one’s financial affairs to reduce tax liability. Tax avoidance means using measures to reduce one’s tax burden. Tax havens are jurisdictions with relatively low taxes and financial secrecy that companies and individuals can use to declare their income to avoid tax at home.
4.2. Tax Noncompliance
Company U.S. Income Tax Effective rate Amazon 10,8354 -129 -1% Delta Airlines 5,073 -187 -4% Chevron 4,547 -181 -4% General Motors 4,320 -104 -2% Prudential 1,440 -346 -24% Netflix 856 -22 -3% IBM 500 -342 -68% U.S. Fortune 500 companies that paid no federal tax Source: ITEP.org (2018 data)
Largest Tax Havens Ireland Cayman & British Virgin Islands Singapore Switzerland Netherlands Luxembourg Puerto Rico Hong Kong Bermuda Source: Zucman 2018
Australian GST Regulation (Unedited Excerpt)
“I had discovered I was paying a huge amount of money to the taxman.
You are so happy that you've finally started earning money - and then you find out
about tax. In those days we paid 19 shillings and sixpence [96p] out of every pound, and with supertax and surtax and tax-tax it was ridiculous - a heavy penalty to pay for making money. That was a big turn-off for Britain. Anybody who ever made any money moved to
America or somewhere else.” (George Harrison on writing the 1966
Beatles song “Taxman”).
Taxman
The government requires buyers to pay a tax of $0.50 on each unit purchased.
This shifts demand to the left (demand falls) by the amount of the tax.
The tax creates a wedge between the price buyers effectively pay ($3.30), and the price sellers receive ($2.80).
Although the tax is levied on buyers, the burden of the tax falls on both buyers and sellers. The price buyers pay is $0.30 higher than before, the price sellers receive is $0.20 lower than before.
Moreover, the quantity traded falls (100 to 90).
Supply
Demand1
$3 $2.80
10090
Price
Quantity
Equilibrium without tax
Demand2
$3.30
Equilibrium with tax
Tax $0.50
4.2.1. Tax Incidence on Consumers
The government requires sellers to pay a tax of $0.50 on each unit sold.
This shifts supply to the left (supply falls) by the amount of the tax. Otherwise, the effects are identical to tax incidence on buyers.
How taxes affect market outcomes:
Taxes discourage market activity: • When a good is taxed, the quantity traded falls; • Buyers pay more for the good and sellers receive
less.
Buyers and sellers share the tax burden. It does not matter who the tax is levied on. The effects on the market and the tax incidence are identical.
Supply1
Demand
$3 $2.80
10090
Price
Quantity
Equilibrium without tax $3.30 Equilibrium with tax
Tax $0.50
Supply2
4.2.2. Tax Incidence on Firms
Supply1
Demand
Price without tax
Price
Quantity
Equilibrium without tax
Equilibrium with tax
Tax
Supply2 Price buyers pay
Price sellers receive
Tax incidence on buyers
Tax incidence on sellers
Supply1
Demand
Price without tax
Price
Quantity
Equilibrium without tax
Equilibrium with tax
Tax
Supply2
Price buyers pay
Price sellers receive
Tax incidence on buyers
Tax incidence on sellers
Because supply is elastic, the price sellers receive does not fall much, so sellers bear only a small burden. In contrast, the price buyers pay rises substantially, so buyers bear most of the tax burden.
Because demand is elastic, the price buyers pay does not rise much, so buyers bear only a small burden. In contrast, the price sellers receive falls substantially, so sellers bear most of the tax burden.
4.2.3. Tax Incidence and Elasticity
Definition: A subsidy is a payment from government, to buyers or sellers, for each unit of good that is bought or sold. Subsidy incidence is the benefit of the subsidy, the degree to which buyers and sellers will be better off as a result.
4.3. Subsidies
Subsidies fulfil two main functions:
(1) Correcting market failures (2) Redistributing resources
Subsidised services in Australia include
• Education • Medicare • First-home owner grant • Childcare and parental leave
The government pays sellers a subsidy of $1.00 for each unit sold. This shifts supply to the right (supply increases) by the amount of the subsidy. Like a tax, the subsidy creates a wedge between the price buyers pay ($2.40), and the price sellers receive ($3.40). In this case the subsidy is paid to sellers, yet the benefits are enjoyed by both buyers and sellers. The price buyers pay is lower than before and the price sellers receive is higher. Moreover, the quantity traded rises as a result of the subsidy. The market outcomes are identical if the subsidy is paid to buyers. How subsidies affect market outcomes: Subsidies encourage market activity: • When a good is subsidised, the quantity traded rises; • Buyers pay less for the good and sellers receive more (the
government makes up the difference). Buyers and sellers share the benefit. It does not matter who receives the subsidy. The effects on the market and the subsidy incidence are identical.
Supply2
Demand
$3
$2.40
120100
Price
Quantity
$3.40
Equilibrium with subsidySubsidy
$1.00
Supply1
Equilibrium without subsidy
4.3.1. Subsidy Incidence on Firms
The demand of first home buyers for housing tends to be relatively elastic. The supply of housing tends to be relatively inelastic.
The subsidy creates a wedge between the price paid by buyers and the price received by sellers.
The price buyers pay does not fall much, so buyers gain a small benefit. In contrast, the price sellers receive rises substantially, indicating that sellers gain most of the benefit.
Price
Quantity0
Price buyers
pay Demand1
SupplyPrice sellers
receive
Price without subsidy
Subsidy Sellers’ share
Buyers’ share
Under this scheme, to assist first time home buyers, the government pays buyers a subsidy of up to $80,000 (depending on income).
Demand2
4.3.2. The First-Home Owners Grant Scheme
4.4. Price Controls Definitions: Factor markets are the markets for the factors of production (land, labour and capital). The labour market is the market where labour is exchanged in return for wages.
Assumptions of the Labour Market • rational agents with perfect information • zero transaction cost and flexible wages • perfect competition in firms’ product markets • Perfect competition in the labour market - many buyers (firms) and sellers (workers) • Workers are homogeneous (i.e. undifferentiated in skills and talents).
The perfectly competitive labour market generates a single market- clearing equilibrium wage (W) for all workers. In reality, wages differ between different types of workers and there is unemployment. The reason lies in certain imperfections of the labour market:
When Broken
Wage Differentials • Compensating Differential • Human Capital • Ability, Effort and Chance • Discrimination • The Superstar Phenomenon • Efficiency Wages
4.4.1. Wage Di!erentials Imperfection Definitions Examples
Compensating Differential
People with similar levels of education earn different wages to offset the (good or bad) non-financial characteristics of different jobs.
Construction and night shift workers (academics) have relatively high (low) earnings.
Human Capital Investments in a specific person to raise productivity and earnings in the future. Because high-ability people are more able to accumulate human capital, it is rational for firms to interpret human capital as a signal of ability.
Education and on-the-job training.
Ability, Effort and Chance
Productivity and therefore wages may differ due to workers’ different natural talents, effort, luck and opportunities.
Discrimination Certain groups in society have fewer labour market and human capital investment opportunities because of others’ prejudice against their personal characteristics.
Job market discrimination based on age, gender, ethnicity, religion, sexual or orientation.
Superstar Phenomenon
Wage differentials between the highest and lowest earners in a profession that are not in line with differences in their talents, effort or productivity, but are caused by zero marginal cost of production.
Best actors, musicians, authors can service all demand through electronic media.
Efficiency Wages
Above-equilibrium wages paid by firms in order to increase worker productivity through better worker effort and health, better quality of job applicants and retention.
Manufacturing industries with fewer supervisors pay wages to stop shirking.
Delving Deeper
A binding price floor is set above the equilibrium price. Price floors result in surpluses of the good. Some sellers are able to sell their goods at the higher price, but others will not be able to. Some method for rationing will naturally develop, for e.g. appealing to the personal biases of the buyers. In the case of minimum wage, the surplus is unemployment. Rationing may lead to discriminatory hiring practices in the labour market. A price floor is only binding if set above the equilibrium price. If set below, it is non-binding as it does not prevent the market from achieving equilibrium.
Supply
Demand
Price floor
$3
$4
10075 125
Wage
Quantity of Labour
Quantity supplied
Quantity demanded
Oversupply
4.4.2. Price Floor: Minimum Wages
Definition: A minimum wage is government's legally binding minimum the price for labour (price floor).