Tax, Subsidy, and General Equilibrium

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1 Tax. rinciples of Microeconomics, Fall hia-hui hen October, Lecture Tax, ubsidy, and General Equilibrium Outline. hap : Tax. hap : ubsidy. hap : General Equilibrium. hap : Exchange Economy Tax Government imposes a $ tax on every unit sold (see Figure ), as discussed in Lecture. The buyer s price is shown on the y-axis. The consumer surplus. buyer s price.... Figure : Tax. and producer surplus both decrease: Δ = ( + ), Δ = ( + ). Government revenue ΔG = +. ite as: hia-hui hen, course materials for. rinciples of Microeconomics, Fall. MIT OpenourseWare ( Massachusetts Institute of Technology. ownloaded on [ Month

The buyer s price is shown on the y-axis. The consumer surplus. buyer s price.... Figure : Tax. and producer surplus both decrease: Δ = ( + ), Δ = ( + ).

2 ubsidy o the deadweight loss is WL = +. The burden of a tax is shared by consumers and producers; the relative amount borne by consumers and producers depends on relative elasticities of demand and supply. If the demand is inelastic (see Figure ), Figure : Tax urden on uyers, Relative Inelastic emand urve. Δ = ( + ), Δ = ( + ), buyers bear most of the burden of the tax. If the supply is inelastic (see Figure ), Δ = ( + ), Δ = ( + ), producers bear most of the burden of the tax. ass-through fraction is the percentage of a tax borne by consumers. It tells the fraction of tax passed through to consumers through higher price. If E =, say the demand is perfectly inelastic (see Figure ), buyers bear all of the tax burden: E =. E E ite as: hia-hui hen, course materials for. rinciples of Microeconomics, Fall. MIT OpenourseWare ( Massachusetts Institute of Technology. ownloaded on [ Month

$If the supply is inelastic (see Figure ), Δ = ( + ), Δ = ( + ), producers bear most of the burden of the tax. ass-through fraction is the percentage of a tax borne by consumers.$

3 ubsidy Figure : Tax urden on roducers, Relative Inelastic upply urve. Figure : Tax urden on uyers, erfectly Inelastic emand urve. ite as: hia-hui hen, course materials for. rinciples of Microeconomics, Fall. MIT OpenourseWare ( Massachusetts Institute of Technology. ownloaded on [ Month

ite as: hia-hui hen, course materials for. rinciples of Microeconomics, Fall.

4 ubsidy... E.. ubsidy Figure : ubsidy. Government subsidizes $ for each unit sold (see Figure ). In this case, sellers price is higher than buyers price: The consumer surplus increases by and the producer surplus increases by = +. Δ = + ; Δ = +. Government expenditure equals the whole area between and under the quantity ΔG = ( E). The deadweight loss is WL = E. Likewise we can discuss the benefit of subsidy: E if E is small, namely, the demand is more inelastic, the benefit of subsidy goes mostly to buyers; E if E is large, namely, the supply is more inelastic, the benefit of subsidy goes mostly to sellers. ite as: hia-hui hen, course materials for. rinciples of Microeconomics, Fall. MIT OpenourseWare ( Massachusetts Institute of Technology. ownloaded on [ Month

Government expenditure equals the whole area between and under the quantity ΔG = ( + + + + E). The deadweight loss is WL = E.

5 General Equilibrium General Equilibrium artial equilibrium. Ignores effects form other markets. General equilibrium. imultaneous determination of the prices and quantities in all relevant markets, taking into account feedback effects. Feedback effect. The price or quantity adjustment in one market caused by price and quantity adjustments in related markets. Example (V and Movie Tickets Markets). The price of a V is $, and the price of a movie ticket is $ at equilibrium. Now tax $ on the movie ticket (see Figure ). The specific process of price change is listed as follows: MOVIE TIKET : M M, rice change:.; V : The price change of movie tickets shifts the demand curve of V. V V, rice change:.; MOVIE TIKET : The price change of V shifts the demand curve of movie tickets. M M, rice change:..; and so on. The final equilibrium prices are (MOV IETIKET ) =.; (V ) =.. If we ignore the feedback effects, we might underestimate the price change bought by the tax. ite as: hia-hui hen, course materials for. rinciples of Microeconomics, Fall. MIT OpenourseWare ( Massachusetts Institute of Technology. ownloaded on [ Month

The price or quantity adjustment in one market caused by price and quantity adjustments in related markets. Example (V and Movie Tickets Markets).

6 General Equilibrium * M M M (a) rice hange of Movie Ticket. V V * V V * V (b) rice hange of V. Figure : General Equilibrium of V and Movie Ticket Markets. ite as: hia-hui hen, course materials for. rinciples of Microeconomics, Fall. MIT OpenourseWare ( Massachusetts Institute of Technology. ownloaded on [ Month

7 Exchange Economy Exchange Economy ssume that: there are two consumers and ; there are two goods, food and clothing; the quantities of food and clothing are and, and has food and clothing, while has food and clothing; they know each others preferences; transaction cost is zero. The edgeworth box is shown in Figure. O lothing (F,)=(F,) O Food Figure : Edgeworth ox. ite as: hia-hui hen, course materials for. rinciples of Microeconomics, Fall. MIT OpenourseWare ( Massachusetts Institute of Technology. ownloaded on [ Month

is zero. The edgeworth box is shown in Figure. O lothing (F,)=(F,) O Food Figure : Edgeworth ox.

Production Possibilities Frontier and Output Market Efficiency. 1 Production Possibilities Frontier

Production Possibilities Frontier and Output Market Efficiency. 1 Production Possibilities Frontier Production Possibilities rontier. Principles of Microeconomics, all hia-hui hen October, Lecture Production Possibilities rontier and Output Market Efficiency Outline. hap : Production Possibilities rontier.