Government Intervention in Free Market PDF

SESSION 11 & 12: EMPLOYING THE ELASTICITY TOOL: GOVERNMENT INTERVENTION IN FREE MARKET  LEARNING OBJECTIVES Explain the effects of a tax on buyers Explain the effects of a tax on sellers  Taxes ▪Everything you earn and almost ev...

SESSION 11 & 12: EMPLOYING THE ELASTICITY TOOL: GOVERNMENT INTERVENTION IN FREE MARKET  LEARNING OBJECTIVES Explain the effects of a tax on buyers Explain the effects of a tax on sellers  Taxes ▪Everything you earn and almost everything you buy is taxed. ▪Who really pays these taxes? oPersonal Income Tax (SITE & PAYE) are deducted from your pay oVAT is included in the price of the things you buy, oEmployer pays the employer’s contribution to the Unemployment Insurance Fund (UIF)? ❖You’re going to discover that it isn’t obvious who pays a tax and that lawmakers don’t decide who will pay!  Taxes Tax Incidence Tax incidence is the division of the burden of a tax between buyers and sellers. When an item is taxed, its price might rise by the full amount of the tax, by a lesser amount, or not at all. If the price rises by the full amount of the tax, buyers pay the tax – buyers’ burden If the price rises by a lesser amount than the tax, buyers and sellers share the burden of the tax - sellers’ and buyers’ burden If the price doesn’t rise at all, sellers pay the tax - sellers’ burden. Tax incidence does not depend on whether the tax law imposes the tax on buyers or on sellers.  Taxes A Tax on Sellers In Figure 6.6, the demand curve is D, and the supply curve is S A tax on sellers is like an increase in cost, so it decreases the supply To determine the position of the new supply curve, we add the tax to the minimum price that sellers are willing to accept for each quantity sold Equilibrium occurs where the new supply curve intersects the demand curve  Taxes A Tax on Buyers A tax on buyers lowers the amount they are willing to pay the seller, so it decreases demand and shifts the demand curve leftward To determine the position of this new demand curve, we subtract the tax from the maximum price that buyers are willing to pay for each quantity bought Customers are will to buy 350m packs of cigarette only if the price including tax is R12. Equilibrium occurs when the new demand meets supply  Taxes Equivalence of Tax on Buyers and Sellers We have seen that in both cases above, consumers pay R4 of the tax and suppliers only pay R2 of the tax. Can we share the tax burden equally?? Value-Added Tax Value-added tax is an example of a tax that the government imposes equally on both buyers and sellers The market for goods, not the government, decides how the tax burden of the Value-Added Tax is shared between firms and consumers. The division of the burden of a tax between buyers and sellers depends on the elasticities of demand and supply  Taxes Tax Division and Elasticity of Demand The division of the tax between buyers and sellers depends in part, on the price elasticity of demand. Two extreme cases; Perfectly price inelastic demand – buyers pay Perfectly price elastic demand – sellers pay The more inelastic the demand, the larger the amount of tax paid by buyers  Taxes Tax Division and Elasticity of Supply The division of the tax between buyers and sellers also depends, in part, on the price elasticity of supply Perfectly price inelastic supply – sellers pay Perfectly price elastic supply – buyers pay The more elastic the supply, the greater the amount paid by buyers  Taxes in Practice Taxes in Practice Taxes usually are levied on goods and services with an inelastic demand or an inelastic supply. Alcohol, tobacco and petrol have inelastic demand, so the buyers of these items pay most of the tax on them. Labour has a low elasticity of supply, so the seller - the worker - pays most of the income tax.  Taxes Taxes and Efficiency In extreme cases of perfectly inelastic demand or supply, a tax does not change equilibrium Qd/Qs, thus there is no DWL. With no tax, marginal social benefit = marginal social cost. The market is efficient: Total surplus is maximized. A tax decreases the quantity, raises the buyers’ price, and lowers the sellers’ price. Marginal social benefit exceeds marginal social cost and the tax is inefficient. The tax revenue takes part of the consumer surplus and producer surplus The decreased quantity creates a deadweight loss.  Taxes Economists propose two conflicting principles of fairness to apply to a tax system: 1.The benefits principle ▪The benefits principle is the proposition that people should pay taxes equal to the benefits they receive from the services provided by the government. ▪This arrangement is fair because it means that those who benefit most pay the most taxes. 2.The ability-to-pay principle ▪The ability-to-pay principle is the proposition that people should pay taxes according to how easily they can bear the burden of the tax. ▪A rich person can more easily bear the burden than a poor person can. ▪So the ability-to-pay principle can reinforce the benefits principle to justify high rates of income tax on high incomes.  Subsidies and Quotas Subsidies A subsidy is a payment made by the government to a producer (Figure 6.12) Production Quotas A production quota is an upper limit to the quantity of a good that may be produced in a specified period (Figure 6.13)  Markets for Illegal Goods A Market for an Illegal Drug When a good is illegal, the cost of trading in the good increases (page 142 version 3) Penalties on Sellers Drug dealers in South Africa face large penalties if their activities are detected These penalties are part of the cost of supplying illegal drugs, and they bring a decrease in supply – a leftward shift in the supply curve Penalties on Buyers Penalties fall on buyers, and the cost of breaking the law must be subtracted from the value of the good to determine the maximum price buyers are willing to pay for the drugs Penalties on Both Sellers and Buyers If penalties are imposed on both sellers and buyers, both supply and demand decrease The larger the penalties and the greater the degree of law enforcement, the larger is the decrease in demand and/or supply END OF SESSIONS 11&12