major economic issues

Document Sample
major economic issues Powered By Docstoc
					Applications to Major Economic Issues
             One of the most fruitful arenas for application
of supply-and-demand analysis is agriculture.
Improvements in agricultural technology mean that supply
increases greatly, while demand for food rises less than
proportionately with income. Hence free-market prices for
foodstuffs tend to fall. No wonder governments have
adopted a variety of programs, like crop restrictions, to
prop up farm incomes.

Impact of Tax
                A commodity tax shifts the supply-and-
demand equilibrium. The tax's incidence (or impact on
incomes) will fall more heavily on consumers than on
producers to the degree that the demand is inelastic
relative to supply.

Minimum Floors and Maximum Ceilings
                   Governments occasionally interfere with
the workings of competitive markets by setting maximum
ceilings or minimum floors on prices. In such situations,
quantity supplied need no longer equal quantity demanded;
ceilings lead to excess demand, while floors lead to excess
supply. Sometimes, the interference may raise the incomes

of a particular group, as in the case of farmers or low-
skilled workers. Often, distortions and inefficiencies result.

Tax Incidence

In economics, tax incidence is the analysis of the effect of
a particular tax on the distribution of economic welfare.
Tax incidence is said to "fall" upon the group that, at the
end of the day, bears the burden of the tax. The key
concept is that the tax incidence or tax burden does not
depend on where the revenue is collected, but on the price
elasticity of demand and price elasticity of supply. For
example, a tax on apple farmers might actually be paid by
owners of agricultural land or consumers of apples.
The theory of tax incidence has a number of practical
results. For example, United States Security payroll are
paid half by the employee and half by the employer.
However, economists think that the worker is bearing
almost the entire burden of the tax because the employer
passes the tax on in the form of lower wages. The tax
incidence is thus said to fall on the employee.
Example of tax incidence
Imagine a $1 tax on every barrel of apples an apple farmer
produces. If the product (apples) is price inelastic to the
consumer (where if price rose, a small demand loss will be

accounted for by the extra revenue), the farmer is able to
pass the entire tax on to consumers of apples by raising the
price by $1: consumers are bearing the entire burden of the
tax; the tax incidence is falling on consumers. On the other
hand, if the apple farmer can't raise prices, because the
product is price elastic (if prices rise, more demand will be
lost than the extra revenue made) the farmer will have to
bear the burden of the tax of face decreased revenues: the
tax incidence is falling on the farmer. If the apple farmer
can raise prices only $0.50, then they are sharing the tax
burden. When the tax incidence falls on the farmer, this
burden will flow back to owners of the relevant factors of
production, including agricultural land and employee
Where the tax incidence falls depends on the price
elasticity of demand and price elasticity of supply. Tax
incidence falls mostly upon the group that responds least
to price (the group that has the most inelastic price-
quantity curve).

Tax burden
Main article: Tax incidence

Diagram illustrating taxes effect
Law establishes from whom a tax is collected. In many
countries, taxes are imposed on business (such
as corporate taxes or portions of payroll taxes). However,
who ultimately pays the tax (the tax "burden") is
determined by the marketplace as taxes
become embedded into production costs. Depending on
how quantities supplied and demanded vary with price (the
"elasticities" of supply and demand), a tax can be absorbed
by the seller (in the form of lower pre-tax prices), or by the
buyer (in the form of higher post-tax prices). If the
elasticity of supply is low, more of the tax will be paid by
the supplier. If the elasticity of demand is low, more will
be paid by the customer. And contrariwise for the cases
where those elasticities are high. If the seller is a
competitive firm, the tax burden flows back to the factors
of production depending on the elasticities thereof; this
includes workers (in the form of lower wages), capital
investors (in the form of loss to shareholders), landowners
(in the form of lower rents) and entrepreneurs (in the form
of lower wages of superintendence).
To illustrate this relationship, suppose the market price of
a product is US$1.00, and that a $0.50 tax is imposed on
the product that, by law, is to be collected from the seller.
If the product is a luxury (in the economic sense of the
term), a greater portion of the tax will be absorbed by the
seller. This is because a luxury good has elastic demand
which would cause a large decline in quantity demanded
for a small increase in price. Therefore in order to stabilise
sales, the seller absorbs more of the additional tax burden.
For example, the seller might drop the price of the product
to $0.70 so that, after adding in the tax, the buyer pays a
total of $1.20, or $0.20 more than he did before the $0.50

tax was imposed. In this example, the buyer has paid $0.20
of the $0.50 tax (in the form of a post-tax price) and the
seller has paid the remaining $0.30 (in the form of a lower
pre-tax price).
Inelastic supply, elastic demand

Because the producer is inelastic, he will produce the same
quantity no matter what the price. Because the consumer is
elastic, the consumer is very sensitive to price. A small
increase in price leads to a large drop in the quantity
demanded. The imposition of the tax causes the market
price to increase from P without taxto P with tax and the
quantity demanded to fall from Q without tax to Q with
tax. Because the producer is inelastic, the quantity doesn't
change much. Because the consumer is elastic and the
producer is inelastic, the price doesn't change much. The
producer is unable to pass the tax onto the consumer and
the tax incidence falls on the producer. In this example, the
tax is collected from the producer and the producer bears
the tax burden. This is known as back shifting.
Similarly-elastic supply and demand

Most markets fall between these two extremes, and
ultimately the incidence of tax is shared between producers
and consumers in varying proportions. In this example, the
consumers pay more than the producers, but not all of the
tax. The area paid by consumers is obvious as the change
in equilibrium price (between P without tax to P with tax);
the remainder, being the difference between the new price
and the cost of production at that quantity, is paid by the

Inelastic demand, elastic supply

Because the consumer is inelastic, he will demand the
same quantity no matter what the price. Because the
producer is elastic, the producer is very sensitive to price.
A small drop in price leads to a large drop in the quantity
produced. The imposition of the tax causes the market
price to increase from P without tax to P with tax and the
quantity demanded to fall from Q without tax to Q with
tax. Because the consumer is inelastic, the quantity doesn't
change much. Because the consumer is inelastic and the
producer is elastic, the price changes dramatically. The
change in price is very large. The producer is able to pass
almost the entire value of the tax onto the consumer. Even
though the tax is being collected from the producer the
consumer is bearing the tax burden. The tax incidence is
falling on the consumer, known as forward shifting.

Similar elasticities: burden shared

Inelastic demand, elastic supply: the burden is on

Macroeconomic perspective
The supply and demand for a good is deeply intertwined
with the markets for the factors of production and for
alternate goods and services that might be produced or
consumed. Although legislators might be seeking to tax
the apple industry, in reality it could turn out to be truck
drivers who are hardest hit, if apple companies shift
toward shipping by rail in response to their new cost. Or
perhaps orange manufacturers will be the group most
affected, if consumers decide to forgo oranges to maintain
their previous level of apples at the now higher price.
Ultimately, the burden of the tax falls on people—the
owners, customers, or workers.
However, the true burden of the tax cannot be properly
assessed without knowing the use of the tax revenues. If
the tax proceeds are employed in a manner that benefits
owners more than producers and consumers then the
burden of the tax will fall on producers and consumers. If
the proceeds of the tax are used in a way that benefits
producers and consumers, then owners suffer the tax
burden. These are class distinctions concerning the
distribution of costs and are not addressed in current tax
incidence models. The US military offers major benefit to
owners who produce offshore. Yet the tax levy to support
this effort falls primarily on American producers and
consumers. Corporations simply move out of the tax
jurisdiction but still receive the property rights
enforcement that is the mainstay of their income.

Other Considerations of Tax Burden
Consider a 5% import tax applied equally to all imports
(oil, autos, hula hoops, and brake rotors; steel, grain,
everything) and a direct refund of every penny of collected
revenue in the form of a direct egalitarian "Citizen's
Dividend" to every person who files Income Tax returns.
At the macro level (aggregate) the people as a whole will
break even. But the people who consume foreign produced
goods will bear more of the burden than the people who
consume a mix of goods. The people who consume no
foreign goods will bear none of the burden and actually
receive an increase in utility. On the producer side, the tax
burden distribution will depend on whether a firm
produces its goods within the sovereignty or outside the
sovereignty. Firms that produce goods inside the
sovereignty will increase their market share and their
profits when compared to firms who offshore their
production. And if the current mix of firms is tilted toward
offshore production then the owners of firms will be
burdened more than the consumers while the
workers/employees will benefit from greater employment


The burden from taxation is not just the quantity of tax
paid (directly or indirectly), but the magnitude of the
lost consumer surplus or producer surplus. The concepts
are related but different. For example, imposing a $1000
per gallon of milk tax will raise no revenue (because legal
milk production will stop), but this tax will cause
substantial economic harm (lost consumer surplus and
lost producer surplus). When examining tax incidence, it is

the lost consumer and producer surplus that is important.
See the tax article for more discussion.
Other practical results
The theory of tax incidence has a large number of practical
results, although economists dispute the magnitude and
significance of these results:

      Because businesses are more sensitive to wages than
    employees, payroll taxes, employer mandates, and other
    taxes collected from the employer end up being borne
    by the employee. The tax is passed onto the employee
    in the form of lower wages.
      If the government requires employers to provide
    employees with health care, the burden of this is likely
    fall on the employee to a great degree because the
    employer may pass on the burden in the form of lower
      Taxes on easily substitutable goods, such as oranges
    and tangerines, may be borne mostly by the producer
    because the demand curve for easily substitutable goods
    is quite elastic.
      Similarly, taxes on a business that can easily be
    relocated are likely be borne almost entirely by the
    residents of the taxing jurisdiction and not the owners of
    the business.
      The burden of tariffs (import taxes) on imported cars
    might fall largely on the producers of the cars because
    the demand curve for foreign cars might be elastic if car
    consumers may substitute a domestic car purchase for a
    foreign car purchase.
      If consumers drive the same number of miles
    regardless of gas prices, then a tax on gasoline will be

  paid for by consumers and not oil companies (this is
  assuming that the price elasticity of supply of oil is
  high, which is incorrect. In this case both the price
  elasticity of demand and supply are very low). Who
  actually bears the economic burden of the tax is not
  affected by whether government collects the tax at the
  pump or directly from oil companies.

Assessing tax incidence is a major economics subfield
within the field of public finance.
Most public finance economists acknowledge that nominal
tax incidence (i.e. who writes the check to pay a tax) is not
necessarily identical to actual economic burden of the tax,
but disagree greatly among themselves on the extent to
which market forces disturb the nominal tax incidence of
various types of taxes in various circumstances.
The effects of certain kinds of taxes, for example, the
property tax, including their economic incidence,
efficiency properties and distributional implications, have
been the subject of a long and contentious debate among
The empirical evidence tends support different economic
models under different circumstances. For example,
empirical evidence on property tax incidents tends to
support one economic model, known as the "benefit tax"
view in suburban areas, while tending to support another
economic model, known as the "capital tax" view in urban
and rural areas.[5]
There is an inherent conflict in any model between
considering many factors, which complicates the model

and makes it hard to apply, and using a simple model,
which may limit the circumstances in which its predictions
are empirically useful.

A General Look at Market Policy Making
When starting an analysis of government policies on
markets it is important to focus on the goals of the policy
makers, for tools that affect markets can be used for many
purposes. In 1990, with the Federal government budget
deficit spiraling even more out of control than before, the
President (Bush) and congressional leaders held a budget
"summit." While the focus of this meeting was to devise
ways to bring down the deficit, secondary interests also
played a role.

One interest group suggested that sin taxes be used. That
is, any new taxes or increases should be on things like
tobacco and liquor. Besides raising more revenue for the
government, sin taxes would discourage the use of these
products, providing secondary health benefits. Another
group suggested imposing an oil import fee. While an $8
per barrel fee would raise $30 billion (Newsweek, May 28,
1990, page 52) it would also lower our dependence on
imported oil. Besides, with gasoline more expensive as a
result, environmentalists argued that this tax would help
curb pollution.

Still further suggestions included axing bad or ineffective
programs which subsidized individuals, for example
cutting postal subsidies for charities (which contribute to
the vast amounts of junk mail and solicitations many of us
endure), railroad subsidies, and artists. Cutting subsidies
for the Small Business Administration, and ranchers who

graze cattle on federal lands (the user fees do not cover the
full cost, so in essence it is a subsidy) has also been

All of these proposals would increase government
revenues or lower government spending, and all
would discourage some activity. There would be less
driving and pollution with the oil import tax, fewer
ranchers and small businesses and less junk mail if those
subsidies were removed or diminished. What is most
interesting here is that instead of focusing on how to raise
revenue or close the gap, the focus is on who would be
affected, and how much. Thus, we get a clear picture of
multiple goals of policy making, and the complications it
entails. While the focus is on closing the deficit, there is
also interest on what is encouraged or discouraged.

So the first issue a policy maker must face is the purpose
of the policy. If the purpose is to raise revenue, most likely
a tax (under one name or another) will be imposed. The
focus will be on the amount of money that the tax will
generate. Alternatively, to cut costs (by reducing
subsidies), again the focus will be on dollars. And a major
focus is who pays those dollars, the seller or the buyer.

But often, there is the behavioral goal; to encourage or
discourage some consumption. A general rule is taxes
discourage consumption or actions, subsidies encourage
consumption or actions. Usually, some consumption is
discouraged if it has potential or real harm or undesirable
characteristics. Taxes on foreign sources of oil, by making
it more expensive and thus lowering the quantity
demanded, remove our liability to future embargoes,
where oil used as a weapon can hurt our economic well-

being. Or if some activity is polluting (like burning wood
in a wood stove or fireplace) making it more expensive
lowers individuals’ propensity to burn. But some activities
are considered beneficial. One reason charitable
contributions are tax deductible is to encourage such
contributions. Farmers are subsidized to ensure and
support domestic sources of food. Local communities and
states will make tax concessions or provide subsidies to
new businesses to bring jobs to a community. Thus,
interestingly, tax payers in one area of the country lower
the cost of consumption in other areas of the country
through local subsidies to bring in businesses and provide
jobs. The subsidies lower the costs to the producers, which
is then passed on to consumers elsewhere.

An alternative approach to encouraging or discouraging
activities is direct limits. This approach is most often
applied to discourage activity. For example, limits might
be placed on the amount of pollution that can be produced,
or on access to wilderness areas for recreational purposes
through a permit system. During the late 1970s, rationing
of gasoline limited its consumption. If a minimal
consumption level is to be mandated (encouraging
consumption) often the government must step in as a
provider. Direct minimum limits are not very common.

Another possible focus of policy is to influence the price
of a good. Rather than to encourage or discourage an
activity, direct policies on prices usually directly benefit
buyers or sellers. Price ceilings, such as rent control, are
designed to directly make housing more affordable. And
price floors, often on agricultural products like peanuts,
barley or milk, are designed to ensure a minimum level of

profit to the producers. In these cases, little attention is
usually given to the overall level of the activity.

Overall government interventions in markets will usually
result in one of two possible outcomes. Government
interventions in markets often drive a wedge between the
consumer's price and the producer's price, or drive a wedge
between the quantity demanded and the quantity supplied.
Along the way there are unintended consequences.
Depending on the policy picked, helping some producer of
a good can hurt or help a consumer of that good. And,
most importantly, keep in mind that nothing is free. Even a
policy that helps both sides of a market has costs. Those
costs just occur outside the market, so in the market
analysis they are masked.

This provides a basis for policy analysis. In the remainder
of this chapter we will explore the technical effects of
different policies, and then utilize the analysis again to
understand goal-driven policy making. We will start with
direct policies, those applied directly on price or quantity.
We will then move onto the indirect policies of taxes and

Direct Policies on Prices
The Wall Street Journal (June 13, 1990, page A15) had an
interesting opinion piece about rent controls in New York
City. When Jerold Ziman bought a $280,000 four story
house, broken up into rent controlled apartments, a
plethora of laws designed to protect tenants of apartments
that have controlled rent prevented him from using the
house for his family. Accompanying statistics to the story
were shocking. The typical landlord of rent controlled

apartments in 1985 owned one building, was an
immigrant, and had an annual income of between 10 and
40 thousand dollars. Tenants of these apartments are from
a different class. Rent controlled apartments are most often
found in middle- and upper-class neighborhoods. So much
so that a legislator (from outside New York City)
introduced a bill to eliminate rent control on any family
with an income of $100,000 or more. Clearly, it is not only
the poor being protected here. Among those mentioned in
the article as benefiting from rent control are Mayor
Dinkins, ex-Mayor Koch, judges, Mia Farrow and Alistair


Price ceilings are designed pure and simple to ensure that
consumers can afford a good. In figure 3.1 we show a
typical market model of supply and demand. Left alone,
the market would achieve equilibrium at a quantity of
Q0 and a price of P0. If a policy maker (for some reason or
another) decides that this price is too high, the result could
be a legally mandated price ceiling. In New York City
(and other places), for example, rapidly expanding rents
provided the political muscle for rent controls.

The impacts of a price ceiling are easily seen. In figure 3.2,
a price ceiling of P1 imposes a wedge between quantity
demanded and quantity supplied. Being able to get only P1,
sellers supply only Qs units (as determined by the supply
curve). But the quantity demanded is Qd, resulting in a
persistent shortage of the good. While the price is lower,
consumers cannot get as much of the good as they would

like. Those customers who actually get to purchase the
good are better off, but some consumers, who are closed
out of the market, are hurt.

The tradeoffs become clear as we analyze the welfare
implications of a price ceiling. Recall from chapter 2 that a
measure of benefits is surplus value. Price ceilings
unambiguously lower the seller's surplus in the market,
and have uncertain affects on total consumer's surplus.

Figure 3.3 illustrates a market prior to and subsequent to
the imposition of a price ceiling. Before the ceiling
equilibrium price is P0 and equilibrium quantity is Q0. At
that point consumer's surplus is the area of the triangle
abP0, and seller's surplus is the triangle P0bc. When a price
ceiling of P1 is imposed, the quantity demanded increases
to Qd while the quantity supplied falls to Qs. Clearly, since
you cannot buy what is not available, the quantity actually
sold will be the latter, at the ceiling price of P1. At this

point seller's surplus is the (much smaller) triangle P1dc,
while consumer's surplus is the quadrangle aedP1. The net
change for consumer's surplus is area of the rectangle
P0fdP1 minus the area of the triangle efb. So, seller's
surplus falls, while the change in total consumer's surplus
is uncertain.

Even if the overall change in consumer's surplus is
positive, it is not clear that consumers as a group are better
off. That is because we have assumed several things. First,
the analysis just performed presumes that units are bought
ordinals according to the demand curve. That is, the
consumer with the highest reservation price buys the first
unit, which with the second highest reservation prices the
second unit, and so on as long as the good is available.
While incentives are such that such an outcome is
possible, it is an unlikely one that gives an upper bound on
consumer's surplus with a price ceiling. If in fact the
consumer with the highest reservation price does not get a
unit, but instead someone with a reservation price near
P1 gets a unit instead, actual consumer's surplus will be

Second, we have been presumptuous to compare the
consumer's surplus enjoyed by those who get the good to
those who do not. In fact, such comparisons - called the
interpersonal comparison of utility - is a major problem of
economics. While overall consumers as a group may be
better, some consumers are better off (enjoying a larger
surplus value) and some are worse off (losing the surplus
value illustrated by triangle efb). It is difficult to establish
the net gain or loss for the entire group. In the context of
the Pareto concepts developed in chapter 1, the market

with and without price ceilings are Pareto Noncomparable

Price ceilings are also deficient on efficiency grounds.
Recall that the total surplus value (consumer's plus
producers) gives a measure of the gains from trade.
Without the ceiling the total surplus in the market was the
triangle abc. After imposing a price ceiling it falls to the
quadrangle aedc. There is a net loss of surplus value,
called a dead-weight loss, since nobody picks it up, of the
triangle ebd. Also, there are two groups of clear losers, the
sellers of the good driven from the market by the
artificially low price and the customers who are unable to
get the good because of shortages. One group clearly
gains, consumers who are able to purchase the good at the
low price.

The relative distribution of gains and losses from price
ceilings depends primarily on the slopes of the supply and
demand curves. Overall, the potential gain in consumer's
surplus for those that get to purchase the good is larger if
the demand curve is steep.