sss/Principles of Microeconomics

Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part XII

The Design of the Tax System

� Taxes provide revenue to the government to remedy externalities, provide publi goods, or regulate the use

of a ommon resour e. This se tion will fo us on how the tax system works and the impa t on e� ient and

equitable allo ations.

� The proportion of in ome devoted to taxes has in reased steadily over time:

As demonstrated in the graph above, the amount of in ome taxed has in reased steadily. The level of taxes varies

substantially from ountry to ountry. Sweden has the highest tax revenue as a per entage of GDP at 49% while

India has the lowest level at 14%. The United States is in the middle at 28%.

The Federal Government:

� The Federal Government relies heavily on in ome tax as the largest sour e of tax revenue.

� The marginal rate of an in ome tax in reases as in omes in rease. Thus, an individual with a higher

in ome will pay higher taxes.

� However, these tax in reases apply only to in ome within an asso iated range (A person who earns $1

million will still only pay 10% of the �rst $8375).

� Payroll Tax: A tax on the wages that a �rm pays its workers

� Considered a so ial insuran e tax as the revenue is earmarked for so ial programs su h as so ial se urity

and medi are.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� Corporate Tax: Represents a mu h lower proportion of the government's revenues. However, orporate pro�ts

are essentially taxed twi e � Initially, orporations are taxes for their pro�ts. Pro�ts are taxed again when

they are distributed to individuals/sto kholders as dividends. This time, the tax takes the form of a personal

in ome tax.

� Ex ise Taxes: Taxes on spe i� goods su h as gasoline, igarettes, and al oholi beverages.

Spending:

1. Transfer Payments: A payment from the government to a itizen. Does not represent transfers in terms of

goods and servi es. Transfer payments represent the largest portion of government spending

2. National Defense: The government spends the 2nd most amount of money on this publi servi e.

3. Health are and other welfare programs

Budget De� it: An ex ess of government spending over government re eipts

Budget Surplus: An ex ess of government re eipts over government spending

� The following graph demonstrates the large proportion of taxes that will have to go to medi are and so ial

se urity when the baby boomer generation rea hes old age:

State and Lo al Government:

� State and lo al government's tax revenue omes from sales tax, property taxes, individual and orporate

in ome taxes, and from revenue shared by the federal government.

� State and lo al government spending goes primarily to edu ation, publi welfare, highways, and other proje ts.

Taxes and E� ien y:

It an be quite di� ult to determine the appropriate level/system of taxation. The most e� ient tax will

raise a high level of revenues for the government while having a low ost to taxpayers. However, the dead-weight

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

loss from taxes needs to be in orporated into the system in addition to the expli it osts of the tax. There is a

large administrative burden asso iated with determining the optimal level of taxes along with implementing and

monitoring the system. This is due to the overly ompli ated nature of our urrent tax system along with all of the

ways in whi h individuals attempt to du k/get out of paying taxes.

The Di�erent Types of Taxes and Measuring Rates:

� Marginal Tax Rates vs. Average Tax Rates:

� Average Tax Rate: Total taxes paid divided by total in ome

� Marginal Tax Rate: The extra taxes paid on an additional dollar of in ome.

� The marginal tax rate is more helpful in measuring how the tax system distorts in entives while the average

tax rate is a more appropriate measure of how mu h of a sa ri� e the taxpayers make. The marginal tax rate

also measures how mu h the tax system dis ourages workers from working.

� Lump-sum Tax: A tax that is the same amount for every person

1. In terms of average and marginal tax rates, the average tax rate will be lower for an individual with

higher in ome while the marginal tax rate is 0.

2. Lump-sum taxes are the most e� ient form of taxes as they do not distort in entives. Thus, they reate

the least amount of deadweight loss.

Taxes and Equity:

� The Bene�ts Prin iple: The idea that people should pay taxes based on the bene�ts they re eive from

government servi es

� The Ability-to-pay Prin iple: The idea that taxes should be levied on a person a ording to how well that

person an shoulder the burden

� Verti al Equity: The idea that taxpayers with a greater ability to pay taxes should pay larger amounts

� Horizontal Equity: the idea that taxpayers with similar abilities to pay taxes should pay the same amount

� Proportional Tax: A tax for whi h high-in ome and low-in ome taxpayers pay the same fra tion of in ome

� Regressive Tax: A tax for whi h high-in ome taxpayers pay a smaller fra tion of their in ome than do low-

in ome taxpayers

� Progressive Tax: A tax for whi h high-in ome taxpayers pay a larger fra tion of their in ome than do low-

in ome taxpayers

It is di� ult to analyze equity and e� ien y when omparing average tax rates when transfer payments are not

a ounted for. Poor families re eive transfer payments in addition to paying taxes. One of the results is that they

a tually have a negative tax rate when transfer payments are in luded in the al ulation. In other words, the in ome

of the poorest families is 30% higher when transfer payments and taxes are in luded.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part XIII

The Costs of Produ tion

Firm's osts determine important aspe ts of the de ision-making pro ess. In this se tion, we will dis uss how a

�rm's osts are al ulated and their asso iated urves.

What are Costs?

� It is important to distinguish between the total revenue, the total ost, and the pro�ts of a �rm �

� Total Revenue: The amount a �rm re eives for the sale of its output.

� Cal ulated as the quantity a �rm produ es times the pri e at whi h it sells its output

� Total Cost: the market value of the inputs a �rm uses in produ tion

� Pro�t: Total revenue minus total ost

� A �rm's pro�ts have to in orporate the osts of produ tion. If osts are higher than revenues, �rms are

making a loss/negative pro�ts

Costs as Opportunity Costs:

� E onomists are always interested in the opportunity ost of any a tion. However, the osts of a �rm an

be separated into two distin t types:

� Expli it Costs: Input osts that require an outlay of money by the �rm

� Examples: Costs of produ tion/inputs, worker's wages, rent

� Impli it Costs: Input osts that do not require an outlay of money by the �rm.

� Examples: The next best alternative o upation (the foregone wages from another employment oppor-

tunity), the opportunity ost of the �nan ial apital that was invested in the business.

� E onomists and A ountants treat osts di�erently. A ountants only in lude the expli it osts ( ash out�ows)

while e onomists in lude both expli it and impli it osts in their al ulations.

� E onomi Pro�t: Total revenue minus total ost, in luding both expli it and impli it osts

* E onomi pro�t a ounts for all of the relevant information and if a �rm is making e onomi losses,

the �rm's owners are failing to over all of the osts of produ tion.

� A ounting Pro�t: Total revenue minus total ost, in luding only expli it osts

� The following �gure demonstrates the di�eren e between osts al ulations:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

The Produ tion Fun tion:

The produ tion fun tion demonstrates the varying osts of a �rm as they adjust the level of produ tion. In

the short run, we use the simplifying assumption that the �rm an not in rease the size of fa tories or the number

of fa tories. Thus, the only way to in rease produ tion is by hiring more workers. The produ tion fun tion

demonstrates the level of produ tion at di�erent numbers of workers:

Sin e e onomists analyze variables �at the margin�, the third olumn of the above table demonstrates a key

aspe t of analysis of the produ tion fun tion. Marginal produ t of labor indi ates the extra marginal in rease

in quantity produ ed given one more worker. The key feature of this olumn of data is that it de reases as the

number of workers in reases. This phenomena is alled diminishing marginal produ t and demonstrates how

the marginal produ t of an input de lines as the quantity of the output de reases.

� At low levels of produ tion, the ma hines, tools, and fa tory �oor are not fully utilized. The result is that

in reases in workers signi� antly in rease the marginal produ t. As more and more workers are hired, there will

not be enough physi al apital for the additional workers. The rowded workspa e results in lower in reases

in marginal produ t of labor. Thus, diminishing marginal produ t o urs.

� The last three olumns of the table demonstrate di�erent types of osts. The following �gure demonstrates

marginal produ t of labor urve and the total osts urve. The shapes of the urves are dire tly related to

one another:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� The total- ost urve to the right demonstrates how the amount of output that is reated diminishes as the in-

rease in total ost stays onstant (the amount of output for ea h additional worker eventually diminishes over

time as more workers are hired). It is the orresponding urve to the produ tion fun tion as it demonstrates

the relationship between total ost and quantity of output.

The Various Measures of Cost:

� The following table demonstrates the di�erent osts for a typi al produ er (in this ase a o�ee produ er):

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

The Graph for these values looks like so:

The di�erent types of ost an be split in the following ways:

� Fixed Costs: Costs that do not vary with the quantity of output produ ed

� Examples: Rent for the fa tory,

� Variable Costs: Costs that vary with the quantity of output produ ed

� Examples: Inputs osts, wages, ingredients, et .

� Average Total Cost: Total ost divided by the quantity of output

AT C = T C/Q

� Average Fixed Cost: Fixed ost divided by the quantity of output

� Average Variable Cost: Variable ost divided by the quantity of output

� Marginal Cost: The in rease in total ost that arises from an extra unit of produ tion

MC = △T C/△Q

� Average total ost tells us the ost of a typi al unit of output if total ost is divided evenly over all of the units

produ ed. Marginal ost tells us the in rease in total ost that arises from produ ing an additional unit of

output.

Cost Curves and Their Shapes:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� The shape of the marginal ost urve demonstrates the phenomena of diminishing marginal returns. For a

brief period, marginal ost de reases as produ tion resour es are fully utilized. However, due to

diminishing marginal produ t, the shape of the MC urve is upward sloping for most quantities of output

� Average �xed ost de reases as the quantity in reases. This o urs be ause the �xed ost is divided over

larger and larger levels of quantity of produ tion

� Average total ost de reases when the marginal ost urve is below it and in reases when the marginal ost

urve is above it. It is �U-shaped� due to the opposing for es of average �xed ost and average variable

ost.

� E� ient S ale: The quantity of output that minimizes average total ost

Costs in the Short Run and in the Long Run:

� In the long run, a �rm is able to adjust the number of fa tories it employs.

� The long-run average total- ost urve is a mu h �atter U-shape than the short-run average total- ost urve.

This is a re�e tion of the produ tion �exibility that omes from a longer time horizon:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� E onomies of S ale: The property whereby long-run average total ost falls as the quantity of output in reases

� Dise onomies of S ale: The property whereby long-run average total ost rises as the quantity of output

in reases.

� Constant Returns to S ale: The property whereby long-run average total ost stays the same as the quantity

of output hanges

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