Taxes and theory of firms
Taxes decrease quantity at which market equilibrates
Increase tax, increase deadweight loss – tax revenue may increase or
decrease
o Area of triangle grows quadratically – faster than the size of the tax
Top of tax wedge is the price consumers pay on the margin for the good – on
the margin, is consumer’s evaluation of the value of the good
Marginal social cost of same unit is supplier’s price – not equivalent when
there is a tax
o Because of this if that marginal good is not produced there is a net loss
to society
o Size of wedge is the total income lost to society through the loss of
output
o Taxes increasingly painful as they get bigger
Total deadweight loss minimized with multiple small taxes
rather than one big tax – broaden tax base
Laffer curve – eventually taxes so large that tax revenue
decreases, tax gets to be self-defeating even on the revenue
side, never mind deadweight loss and lost output
o Every incremental increase less effective in raising revenue, more
effective at raising deadweight loss – leads to policy prescription for
broad tax base
o As we choose different activities to tax, stay away from those with big
elasticity of supply and/or demand
o Rationale for more taxes on wealthy – decreasing marginal utility of
income – push for progressive rather than regressive taxation, better
for aggregate social welfare
Income elasticity of demand – greater than 1, a luxury good
Autarky – state of being without trade
Individual markets in individual nations too small to impact world price
o Not always true – Korea, Taiwan, Japan and semiconductor market;
but for most commodities true
Trade
o Where world price higher than domestic, nation exports
Output expands to point where domestic supply intersects
world price
Domestic price also goes up, quantity demanded domestically
decreases
New equilibrium price is world price
Producer surplus expands, consumer surplus shrinks, but total
surplus rises – national income rises
o Where domestic price higher than world, nation imports
When open economy to world price, domestic price falls to
world price
Domestic suppliers cannot succeed in market, producer
surplus falls
Consumer surplus rises, new equilibrium where world price
intersects domestic demand
Amount imported is the amount domestic demand exceeds
domestic supply at the world price line
o Ways to slow down free trade – tariffs, quotas, but tariffs better
because generate revenue
Tariff still causes reduction in national welfare by reducing
quantity through artificially raising price, but some additional
benefit from money raised through tariff – generally fairly
appealing policy option, but can lead to trade war through
constantly increasing tariffs
By contrast, can use reduction in tariffs as a tool to gain policy
objectives