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Taxes and Government Intervention

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Government Policies and Market Equilibrium

Governments can intervene in markets using policies such as taxes, price floors, and price ceilings, which interact with the invisible hand of prices[cite: 238]. While the equilibrium point in a free market maximizes social surplus (the sum of consumer and producer surplus)[cite: 249], these policies can affect the equilibrium price, quantity, and the distribution of surplus.

Tax Incidence

Governments levy taxes on goods and services for various reasons, including raising revenue for redistribution or public goods, or to discourage certain activities[cite: 252, 253, 255, 258]. A specific tax is a tax per unit of goods sold[cite: 273]. When a specific tax of 'T' per unit is imposed on sellers, it creates a wedge between the price buyers pay ($P_b$) and the price sellers receive ($P_s$), where $P_b - P_s = T$[cite: 308]. This tax wedge causes the supply curve to shift vertically upwards by the amount of the tax 'T' when viewed from the buyer's price perspective[cite: 319].

Key effects of a specific tax:

  • New Equilibrium: The quantity sold in the market decreases[cite: 341, 353].
  • Price Changes: Buyers pay a higher price than the original equilibrium price ($P^$)[cite: 348], and sellers receive a lower price than $P^$[cite: 350].
  • Tax Revenue: The government raises revenue equal to the new quantity sold multiplied by the tax per unit ($Q_{hat} \times T$)[cite: 343].
  • Tax Incidence (Burden): The burden of the tax is shared between buyers and sellers. Tax incidence refers to how much of the tax is paid by consumers and how much by producers[cite: 354, 355].
  • Elasticity and Tax Incidence: The burden of the tax is divided based on the elasticity of demand and supply curves at the equilibrium price[cite: 385]. The relatively inelastic side of the market bears a larger burden of the tax[cite: 380].
    • If demand is more inelastic than supply, consumers bear a larger portion of the tax[cite: 363, 372, 381].
    • If supply is more inelastic than demand, sellers bear a larger portion of the tax[cite: 374, 376, 382].
    • If demand and supply have equal elasticity, the tax burden is shared equally[cite: 384].
  • Deadweight Loss: The imposition of a tax causes a deadweight loss, which is a reduction in total surplus (consumer surplus + producer surplus + government revenue) compared to the free market equilibrium[cite: 420, 421]. This represents the loss of potential surplus from trades that do not occur due to the tax[cite: 424]. The deadweight loss increases as the elasticity of supply or demand increases[cite: 427, 429].

The analysis of tax incidence is the same whether the tax is imposed on buyers or sellers[cite: 430, 432].

Price Ceiling (Price Cap)

A price cap or price ceiling is a maximum price that sellers can charge for a good or service, imposed by the government[cite: 447].

Key effects of an effective price ceiling:

  • Effective Price Ceiling: For a price ceiling to be effective, it must be set below the market equilibrium price ($P^*$)[cite: 457].
  • Excess Demand: An effective price ceiling leads to a situation of excess demand, where the quantity demanded exceeds the quantity supplied at the controlled price[cite: 463].
  • Quantity Sold: The quantity sold in the market is determined by the quantity supplied at the price ceiling, which is less than the equilibrium quantity[cite: 461].
  • Surplus Transfer: Price ceilings transfer surplus from producers to consumers by lowering the price consumers pay[cite: 464, 466].
  • Deadweight Loss and Rationing: Price ceilings can cause deadweight loss due to the reduced quantity traded and can lead to rationing issues because of the excess demand[cite: 464, 466].

Price Floor

A price floor is a minimum price that sellers can charge for a good or service, imposed by the government[cite: 467].

Key effects of an effective price floor:

  • Effective Price Floor: For a price floor to be effective, it must be set above the market equilibrium price ($P^*$)[cite: 469].
  • Excess Supply: An effective price floor leads to a situation of excess supply, where the quantity supplied exceeds the quantity demanded at the controlled price[cite: 469, 470].
  • Quantity Sold: The quantity sold in the market is determined by the quantity demanded at the price floor, which is less than the equilibrium quantity.
  • Producer Protection: Price floors are intended to safeguard sellers or producers by ensuring a minimum price[cite: 471].
  • Deadweight Loss: Price floors can cause deadweight loss due to the reduced quantity traded.

These government interventions alter the natural market equilibrium and can have significant impacts on prices, quantities, and the welfare of both consumers and producers.

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