Microeconomics
rockshan19977
lecture6.pdf
!33
Government Prices and Markets: Block 2
6.1. Government Failure 6.2. Welfare Effects of Taxation 6.3. Welfare Effects of Subsidies 6.4. Welfare Effects of Trade Restrictions
Lecture 6 Government Failure
Reasons for Government Failure
• Administrative cost of intervention (bureaucracy; monitoring, compliance enforcement) exceeds the benefit • Government pursues the wrong objectives
• Vested interest: Government pursues its own political interest and not the public interest • Regulatory capture: Government pursues the interest of special interest groups or firms through lobbying • Paternalism: Government pursues “nanny state” objectives that violate consumer sovereignty • Governments pursues multiple conflicting interests • Policy myopia: Intervention provides quick fixes that work only short term
• Government intervention fails to correct the market failure • Information failure: government lacks knowledge, expertise and information to devise optimal regulation • Compliance cost of firms or consumers is excessive relative to market failure • Intervention has unintended consequences that deepen existing or create new market failures • Intervention disincentivises economic agents
Definition: Government failure happens when government intervention fails to correct or exacerbates market failure.
6.1. Government Failure Government has an important role as an alternative to the market as an allocator of resources. However, just as markets can fail, government intervention can have adverse effects through government failure and by creating a deadweight welfare loss.
Definition: Deadweight loss is the reduction in total surplus that results from a market distortion, such as from direct regulation (tax, subsidy) or trade restrictions (tariffs or quotas).
I think some additional regulation (of Wall Street) is needed. But I don’t think you can rely on regulators, because they fail along with the
market (Gary Becker, 1930-2014)
Government has become too responsive to trivial concerns at the
expense of our liberty, and dependent on where TV journalists point their cameras
(William Niskanen, 1933–2011)
The tax creates a wedge between the price paid by buyers, and the price received by sellers.
The price buyers pay rises, and the price sellers receive falls.
The quantity traded is lower than in the equilibrium without tax.
Price
Quantity0
Price buyers
pay
Quantity without tax
Demand
Supply1
Equilibrium without tax
Quantity with tax
Equilibrium with tax
Price sellers
receive
Tax
Supply2
6.2.1. Welfare Effects of Taxation - Deadweight Loss
Consumer surplus
Producer surplus
Price
Quantity0
Price buyers
pay
Quantity without tax
Demand
Supply1
Quantity with tax
Price sellers
receive
Supply2
Consumer surplus
Tax revenue
The tax reduces the welfare of both buyers and sellers: • Consumer surplus is reduced because buyers purchase
a lower quantity at a higher price. • Producer surplus is reduced because sellers sell a lower
quantity at a lower price.
The government raises tax revenue equal to the size of tax times the quantity traded. It measures the benefit that the government derives from the tax.
Because tax revenue funds the provision of goods and services, households are the ultimate beneficiaries of taxation.
The deadweight loss of taxation is the area of the triangle between demand, supply and the quantity with tax. It was part of the total surplus without tax, but is not part of the total surplus with tax.
The deadweight loss exists because the revenue raised by the tax is less than the loss of consumer and producer surplus due to the tax.
Producer surplus
6.2.1. Welfare Effects of Taxation - Deadweight Loss
Deadweight loss
Tax reduces quantity traded from Q1 to Q2.
At every quantity between Q1 and Q2 the value to the marginal buyer exceeds the cost to the marginal seller.
The difference between these values equals the gains from trade that are lost because the transaction does not occur.
The tax prevents any transaction for which the gains from trade are less than the size of the tax.
Price
Quantity0
Price buyers
pay
Q1
Demand
Supply1
Price sellers
receive
Tax
Supply2
Value to buyers
Cost to sellers
Lost gains from trade
Q2
6.2.1. Welfare Effects of Taxation - Deadweight Loss
A tax has a deadweight loss because it induces buyers and sellers to change their behaviour.
The tax raises the price paid by buyers, so they consume less. At the same time, the tax lowers the price received by sellers, so they produce less.
Hence the equilibrium quantity in the market shrinks below the optimal quantity.
The more responsive buyers and sellers are to changes in the price, the more the equilibrium quantity shrinks, and the greater the deadweight loss.
6.2.2. Welfare Effects of Taxation - Elasticity
A small tax has a small effect on buyer and seller behaviour (and vice versa). Because the quantity traded is close to the optimal quantity, the deadweight loss is small. Because the size of the tax is small, tax revenue is small.
As the size of the tax rises, the effect on buyer and seller behaviour also grows. Tax revenue initially increases because the size of the tax is growing proportionately faster than quantity traded is falling. The deadweight loss grows faster than tax revenue because the size of the tax, and the difference between the quantity with and without the tax, both increase.
As the size of tax the continues to increase, it eventually reaches a point where the quantity traded falls proportionately faster than the size of the tax grows. Tax revenue falls. The deadweight loss continues to grow at an increasing rate.
6.2.3. Welfare Effects of Taxation - Size of Tax
Consumer surplus is increased by the subsidy because buyers purchase a higher quantity at a lower price.
Producer surplus is increased by the subsidy because sellers sell a higher quantity at a higher price.
The government pays the cost of the subsidy (the size of the subsidy times the quantity traded).
The cost of the subsidy subtracts from government revenue. Each dollar spent as a subsidy is a dollar that cannot be spent on the provision of goods and services.
6.3.1. Welfare Effects of Subsidies - Cost
Price
Quantity0
Demand
Quantity without subsidy
Subsidy
Supply
Price without subsidy
Price buyers
pay
Quantity with
subsidy
Price sellers
receive
F
A
B C
D E
G
Without subsidy With subsidy Change
Consumer surplus A+B A+B+D+E Gain D + E
Producer surplus D+G B+C+D+G Gain B + C
Cost of subsidy None –(B+C+D+E+F)
Lose B+C+D+E+F
Total surplus A+B+D+G A+B+D+G–F Lose F
6.3.2. Welfare Effects of Subsidies - Deadweight Loss
Deadweight loss The deadweight loss from a subsidy is the amount by which the
cost of the subsidy exceeds the increase in consumer and producer surplus.
At every quantity between Q1 and Q2, the value to the marginal buyer is less than the cost to the marginal seller (the gains from trade are negative).
The subsidy causes buyers and sellers to participate in transactions that would otherwise not have occurred.
Equilibrium without subsidy
The subsidy creates a wedge between the price paid by buyers and the price received by sellers. Both are better off - the price buyers pay falls and the price sellers receive rises. The quantity traded is higher than in the equilibrium without subsidy.
To assess overall efficiency we must compare the increased welfare of buyers and sellers with the government’s cost of the subsidy.
If the world price is higher than the domestic price, the country will be an exporter of the good (it has a comparative advantage). Domestic sellers will want to receive the higher prices available in the world markets. If the world price is lower than the domestic price, the country be an importer of the good. Domestic buyers will quickly start buying the good at lower prices from world markets.
6.4. Welfare Effects of Free Trade
In a closed economy buyers can only purchase goods from domestic sellers who can only sell to domestic buyers. When an economy is opened to international trade, buyers can buy goods from world markets and sellers can sell into world markets. In a small open economy, domestic buyers and sellers have a negligible effect on world markets. They are price takers, they take the world price, the price of a good that prevails in the world market.
When a country allows trade and imports, domestic consumers of the good are better off and domestic producers of the good are worse off. When a country allows trade and becomes an exporter of a good, domestic producers of the good are better off and domestic consumers of the good are worse off. On the whole, free trade raises the overall economic wellbeing of a nation, for the gains of the winners exceed the losses of the losers.
Quantity
Domestic Supply
Domestic Demand
P1
Q1Qd Qs
CS
B
A
C
In a closed economy, the domestic equilibrium price is P1 and the quantity traded is Q1.
If the world price is higher than P1, when this market is opened to international trade, sellers are not willing to accept any price below the world price.
The domestic price rises to the world price and domestic sellers produce the quantity QS.
Because the price has risen, the domestic quantity demanded falls to QD. The difference is exported to world markets.
The increase in the domestic price reduces consumer surplus and increases producer surplus: •Area A is producer surplus in a closed economy. •Area B is surplus that is transferred from consumers to producers when the price rises to the world price. •Area C is the gains from free (international) trade.
6.4. Welfare Effects of Free Trade: exporting country
Exports
World price
CS
PS
A
C
Quantity
Domestic Supply
Domestic Demand
World price
P1
Q1 QdQs
PS
B
In a closed economy, the domestic equilibrium price is P1 and the quantity traded is Q1.
If the world price is lower than P1, when this market is opened to international trade, buyers are not willing to pay any price above the world price.
The domestic price falls to the world price and domestic sellers produce the quantity QS.
Because the price has fallen, the domestic quantity demanded rises to QD. The difference is imported from world markets.
The fall in the domestic price increases consumer surplus and reduces producer surplus: •Area A is consumer surplus in a closed economy. •Area B is surplus that is transferred from producers to consumers when the price falls to the world price. •Area C is the gains from free (international) trade.
6.4. Welfare Effects of Free Trade: importing country
Imports
CS
6.4. Welfare Effects of Trade Restrictions
However, government intervenes and imposes trade restrictions (protectionist policies) for some of the following reasons: • Domestic jobs • National security • Infant industry • Unfair competition • As a bargaining chip
The Sydney Morning Herald- The eternal temptation in international trade is protectionism: please buy all our exports, but we’ll be importing as few as possible of your exports. It’s tempting because, to the voters in every country, it seems just common sense to favour your own industries over their rivals in other countries.
The South China Morning Post- Can China meet US trade war demands on IP theft and forced technology transfer? Systemic IP theft in China costs US companies at least US$50 billion per year, according to a US Trade Representative (USTR) report published in April 2018, following an investigation under Section 301 of the Trade Act of 1974. The US claims the Chinese government is coordinating an espionage campaign designed to capture cutting-edge technology to boost industrial policy. Outright theft of US IP is a key part of this strategy, the US argues.
QdT
PS
6.4. Welfare Effects of Free Trade: Tariff The increase in the domestic price increases producer surplus and decreases consumer surplus: • Area A is surplus that is transferred from consumers
to producers as a result of the tariff. • Area C is the revenue that the government receives
from tariff. This area was part of consumer surplus under free trade.
• Areas B and D are part of consumer surplus under free trade, but do not contribute to the total surplus with a tariff. Therefore, area B + D is the deadweight loss from the tariff.
Notice that areas B and D are part of the gains from free trade. The tariff moves the market closer to the equilibrium without trade.
A tariff causes a deadweight loss because it is a type of tax. The tariff raises the price that domestic producers can charge above the world price, encouraging them to increase production. It also raises the price that domestic buyers pay, encouraging them to reduce consumption.
QsT
New Imports
Quantity
Domestic Supply
Domestic Demand
Pw
Old Imports
Qs Qd
CS
A B DC Pw +Tariff
