Lecture 4 Microeconomics

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Lecture 4 Microeconomics

• Welfare Economics and Taxation

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Outline

• Introduction to welfare economics
• Pareto-efficiency and distortions
• Consumers surplus
• Producers surplus
• Application to taxation of gasoline.

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Welfare economics

• How good is the competitive market to allocate
  resources?
• Positive question How does it work?
• Normative question How well does it work?

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Pareto-efficiency
An allocation is Pareto-efficient if it is
impossible to move to another allocation which
would

• make at least one individual better off and
• no other individual worse off.

Uncompensated Pareto improvement
Compensated Pareto improvement
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Pareto-efficiency vs. -improvement
Improvement Movement from one state to another
Welfare of person 2
F
E
Efficiency state from which no improvement is
possible
B
A
Inefficiency state from which improvement is
possible
C
D
Welfare of person 1
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Consumers surplus
p
first unit of good q
Consumers surplus
Expenditure
p0
PD(q)
q
q0
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Consumers surplus

• Consumers surplus is the difference between the
  total willingness to pay for a given quantity of
  a good and the total consumption expenditure
  actually paid to get the given quantity of a
  good.

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Producers surplus
p
PS(q)
producers surplus
p0
Total variable cost
q
q0
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Producers surplus

• Producers surplus is the difference between
  total revenue and total (variable) cost.

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The competitive market and Pareto-efficiency
p
PS(q)
Command and control
Dead weight loss or Excess burden
Competitive equilibrium
p
PD(q)
q
q
q
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The first welfare theorem
The competitive equilibrium is
Pareto-efficient.
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Application of D-S Theory Taxation.

• The government wants to increase the tax on
  gasoline, but would like to know in advance

how much revenue the tax will produce
What the incident of the tax is
Social cost
What the the social costs are?
incident
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Revenue effect
Tax up gt revenue
Tax up gt quantity sold down gt revenue down
Tax revenue
Laffer point
Tax rate
0
100
t
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Result I
If the purpose is to raise revenue,
the government should

• tax heavily objects with an inelastic tax base
  and
• tax lightly objects with an elastic tax base.

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The tax incident

• Two relevant prices
• The demand price pd
• The supply price ps
• The difference between the two is the tax rate t
• t pd - ps

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A quantity tax collected from producers
PS(q)t
Jump Q
p
PS(q)
E1
pd
Consumer
E0
t
p0
Producer
ps
PD(q)
q
q1
q0
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Question

• Would the outcome be different if the taxman
  collected the tax from consumers rather than from
  producers?

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Result II

• It does not matter for the equilibrium whether
  sellers or buyers are responsible for paying the
  tax.
• Those who are responsible for paying the tax can
  pass on a proportion to the other party.
• How much, depends on the elasticity of demand and
  supply.

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Two special cases

• If supply is perfectly elastic (horizontal), then
  demanders pay the tax.
• If supply is perfectly inelastic (vertical), then
  suppliers pay the tax.

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A quantity tax perfectly elastic supply
p
E1
pd
PS(q)t
t
E0
p0
ps
PS(q)
PD(q)
q
q0
q1
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A quantity tax perfectly inelastic supply
PS(q)
p
E0
p0
pd
t
ps
PD(q)
q
q1
q0
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Daltons formula
Elasticity of supply
Elasticity of demand
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The dead weight cost of taxation
Tax revenue
p
PS(q)
E1
pd
Deadweight loss
A
B
E0
p0
t
D
C
ps
PD(q)
q
q1
q0
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Social Cost of Taxation

• Loss in consumers surplus AB
• Loss in producers surplus CD
• Tax revenue - AC
• Social loss BD

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Result III

• Taxation introduces a distortion and
• creates a deadweight loss.
• Environmental benefits?

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Whats next
This where we are going