Chapter 8: Application: The Costs of Taxation

8-1: The Deadweight Loss of Taxation

How a Tax Affects Market Participants

  • Recall that the benefit received by buyers is the consumer surplus and the benefit received by sellers is the producer surplus
  • The tax revenue that the government receives is the size of the tax times the quantity of a good; T x Q
    • Graph: Screen Shot 2022-10-25 at 5 02 20 PM
  • The following graph and bullets represent what taxes do to an economy’s well-being: Screen Shot 2022-10-25 at 5 02 20 PM
  • Welfare without a Tax
    • The total surplus in a market is reprsented by the entirety of the triangle up to the equilibrium point, as the government isn’t driving a tax wedge into it
  • Welfare with a Tax
    • With the tax, both the consumer and producer surplus is stifled; they only receive a surplus of sizing of triangles A and F, respectively
  • Changes in Welfare
    • After the tax, both consumers and producers are left worse off while the government is better for it
    • The drop in total surplus is called the deadweightloss and is represented by the area of C + E

Deadweight Losses and the Gains from Trade

  • Scenario of how taxes cause deadweight losses: Imagine a cleaner, Malik, and a homeowner, Mei
    • Mei’s value of cleaning the house is $120, and Malik’s cost is $80, so a fair pricing would be $100 (surplus of $40)
    • If the government levies a $50 tax, there is no good pricing for Malik and Mei
      • If Mei pays $120, then Malik only receives $70
      • If Malik charges $80, then Mei pays $130
    • Business is called off, thus resulting in a deadweight loss
  • Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.
  • The graph from before represents the deadweight loss, as those closer to the equilibrium point are closer to the margin and will thus stop doing business if it stops being lucrative

8-2: The Determinants of the Deadweight Loss

  • When the supply/demand is elastic, then the size of the deadweight loss increases drastically, as more buyers/sellers are willing/able to exit the market
  • Visual Representation: Screen Shot 2022-10-25 at 5 14 39 PM
  • General rule: the greater the elasticities of supply and demand, the larger the deadweight loss of a tax.

8-3: Deadweight Loss and Tax Revenue as Taxes Vary

  • The size of the tax can change the deadweight loss and tax revenue
  • If the tax is too small, then the government might not realize enough revenue, but if the tax is too large, then it may shrink the market can cause the government (and market) to fail
  • Graphics: Screen Shot 2022-10-25 at 5 18 10 PM
  • The size of the deadweight loss is exponential compared to the size of the tax
    • If a tax doubles, then the width and height of the deadweight loss doubles, thus making it increase by a factor of 4

Lecture Notes

  • A subsidy actually hurts the total surplus of an economy, as pushing the quantity past its equilibrium leads to a loss in surplus

Chapter 9: Application: International Trade

9-1: The Determinants of Trade

The Equilibrium without Trade

  • Scenario: Imagine a country named Isoland with a textile market that is isolated from the rest of the world
    • Because they are isolated, the textile market consists only of Isolandian buyers and sellers
    • Graph: Screen Shot 2022-10-25 at 5 24 18 PM
  • A new president is elected and advocates for free trade, asks three questions:
    1. If the government allows Isolandians to import and export textiles, what will happen to the price of textiles and the quantity of textiles sold in the domestic textile market?
    2. Who will gain from free trade in textiles and who will lose, and will the gains exceed the losses?
    3. Should a tariff (a tax on textile imports) be part of the new trade policy

The World Price and Comparative Advantage

  • First question that must be asked is whether or not Isoland will be a textile exporter or importer
  • Economists must compare the current Isolandian price of textiles to other prices of textiles; the current, prevailing price worldwide is called the world price
    • If the world price is greater than the domestic price, then Isoland will become an exporter (producer); if it is lower, then Isoland will become an importer (consumer)
    • Shows if Isoland has a comparative advantage in producing textiles, thus clarifying what Isoland should specialize in

9-2: The Winners and Losers from Trade

  • Must begin with the assumption that Isoland is a small economy and that its actions will have a negligible effect on the world markets; specifically, Isoland will not affect the world price of textiles
    • Economies that cannot affect the price are called price takers; they take the world price

The Gains and Losses of an Exporting Country

  • Assume that Isoland becomes an exporting country
  • After trade is allowed, the domestic price of textiles rises to the world price of textiles
    • Graph: Screen Shot 2022-10-25 at 5 46 05 PM
  • The domestic quantity suppplied is higher than the domestic quantity demanded, but that’s ok because the surplus is sold off as export
  • Though quantities differ, the world market as a participant keeps the domestic market in equilibrium
    • The horziontal line for world price represents the completely elastic world demand for textiles
  • There are pros and cons; the domestic price increases, so domestic producers are better off while domestic consumers are not
    • The total surplus increases at the cost of consumer surplus; sellers beenfit much more in an exporting country than consumers
  • Two conclusions can be made:
    • When a country allows trade and becomes an exporter of a good, domestic producers of the good are better off, and domestic consumers of the good are worse off.
    • Trade raises the economic well-being of a nation in the sense that the gains of the winners exceed the losses of the losers.

The Gains and Losses of an Importing Country

  • Assume that Isoland becomes an importing country
  • After trade is allowed, the domestic price of textiles lowers to the world price of textiles
    • Graph: Screen Shot 2022-10-25 at 6 01 06 PM
  • The domestic quantity demanded is higher than the domestic quantity suppplied, but that’s ok because the shortage is bought as import
  • The supply curve is elastic because Isoland can buy as much of the good as they want at the world price

The Effects of a Tariff

  • Tariff: A tax on imported goods from other countries
    • A tariff does not apply to an exporting country because no one would import goods
  • Graph that shows the effect of a tariff: Screen Shot 2022-10-27 at 10 57 56 PM
    • Area D represents the loss from the overproduction of textiles, while area F represents the loss from the underconsumption of textiles
      • Tariff incentivizes marginal sellers to produce at a profit because the tariff raises the price
      • Tariff deincentivizes marginal buyers to purchase because the tariff raises the price
  • After the tariff, the price of the good rises to the equilibrium price before opening up to international trade
    • Domestic sellers are better off (sell at a higher price), domestic buyers are worse off (buy at a higher price), and the government gains rvenue
  • There is a deadweight loss, but it does not amount to the increase in surplus compared to a purely domestic market

Other Benefits of International Trade

  • Increased variety of goods: Different goods can only be produced in different countries
  • Lower costs through economies of scale: Some goods have lower costs of production if created in bulk; having specialized countries allows for a more efficient allocation of resources
  • Increased competition: Less likelihood of overwhelming market power because the market is bigger
  • Increased productivity: Only the most productive firms survive and thrive, thus increasing productivity
  • Enhanced flow of ideas: Import of advanced technologies can help developing countries develop faster

9-3: The Arguments for Restricting Trade

The Jobs Argument

  • Importing goods could destroy domestic firms and cause a lack of jobs
    • Quite the opposite; new jobs open up as a result of trade (merchants, ambassadors, etc.)
    • Workers in inefficient industries move to advantageous ones
  • Isoland will always have a comparative advantage in some good, so there will always be jobs

The National-Security Argument

  • If a domestic market for defense is non-existent (i.e. gun industry, or steel industry to make weaponry), then if war breaks out, the country will be vulnerable due to its dependencies on other countries
    • Argument is legitimate but may be used too liberally; companies who wish to protect their own interests may push the argument extremely fast and exaggerate their roles in national security
  • Some may see a lower steel price as a way to stockpile weaponry at a lower cost

The Infant-Industry Argument

  • New industries might ask for protection from foreign industries in order to get off the ground and become competitive
    • Old industries might ask the same in order to adjust to new conditions
    • Hard to implement and determine effectiveness; must determine which industries will become profitable and if that protection is worth it
      • Picking such industries is difficult, and protections may be more permanent than temporary due to lobbying
  • Argument is flawed; if an industry is projected to be profitable, then owners would take a loss in the short term in order to gain in the long run

The Unfair-Competition Argument

  • Different laws in different countries can make it hard for some countries to compete
    • If one country provides subsidies or allows for child labor, then they will have an advantage
  • Lower price is not a bad thing; it just means that the country is not competitive in that industry alone and can instead focus on other industries
    • If foreign industries are subsidized, then there is a lower cost of good and no waste of taxpayer dollars

The Protection-as-a-Bargaining-Chip Argument

  • Governments can threaten and use tariffs as a way to remove other tariffss and lead to freer trade
    • If the threat doesn’t work, then imposing the tariff would hurt the economic welfare of a country, and if a country doesn’t follow through with its tariff, then it loses its standing and reputation

Lecture Notes

  • Ricardian Trade Model: Gains in trade are due to differences in opportunity costs (AKA comparative advantage)
  • Quota: A limit on the quantity of imports
    • Same effect as a tariff, but there is no tax revenue, so the decrease in total surplus is even greater
  • Collective Protection Problem
    • Few producers vs. many consumers, easier to organize