Source: Source: Image of Tax Graph created by Kate Eskra, Image of Welfare Analysis of Tax Graph created by Kate Eskra, Image of Subsidy Graph created by Kate Eskra, Image of Welfare Analysis of Subsidy Graph created by Kate Eskra
Hi. Welcome to Economics. This is Kate. This tutorial is Applications of Regulatory Intervention. As always, my key terms are in red and my examples are in green. So in this tutorial, we'll be talking about the effect of a tax on consumers and sellers. You'll see it on a graph. As well as, the effects of a subsidy on both consumers and sellers. And we'll be using welfare analysis to discuss the impact of both taxes and subsidies.
In order to use welfare analysis, we need to understand consumer surplus, which is the difference between what consumers pay and what they're willing to pay for a good; producer surplus, which is the difference between what producers receive and what they would have received for the good; and deadweight loss, which is a variable, like a tax, that decreases the producer and consumer surplus. OK.
So getting right into it. Here we have a graph for a good. We have some initial supply and demand. OK, so Q1 and P star represented the initial equilibrium, quantity, and price. When we put a tax on a good, this is a per unit tax on sellers. So what that's going to do is shift supply up and to the left, because the producer has to pay more. They have to pay an amount of the tax for every unit that they sell.
So now that it's shifted up and to the left, this vertical distance between the supply curves represents the amount of the tax. What that's going to do is increase the price that consumers have to pay, up here, to PC. But that's not the price that producers receive. Remember, they have to pay per unit this vertical distance to the government in taxes. So that means that the price they receive is actually down here.
That's also going to be decreasing the quantity that is sold. So if we were going to use welfare analysis, what would do is to say, OK, before the tax was implemented we have consumer surplus shaded here in blue. All of these consumers on the demand curve were willing to pay a higher price than they received it for. All of this green area is producer surplus, because all of these people along the supply curve, those producers were actually willing to supply it, or sell it for less than they got. So that's producer surplus.
This area of the consumer and producer surplus combined is as big as it possibly can get when the market is here in equilibrium. There is no deadweight loss as of this point. OK. Now that we have the tax, though, what is going to happen?
Now let's remember-- I didn't want to confuse you by having this on here and kind of getting rid of some of these words-- but this is the decrease in supply that we saw, OK? So that's why consumer surplus is shrinking, because they are paying this price up here. So the blue area definitely shrinks.
Sellers are receiving a lower price. down here, remember, from the last slide. So their producer surplus certainly also shrinks. Let's get that out of there. This area in here that used to be both consumer and producer surplus is now the tax revenue going to the federal government. OK? That represents a redistribution of income.
And this, also, that used to be realized by consumers and producers, is now deadweight loss. The quantity that was being sold is gone. There's less quantity being sold. So because of that, this deadweight loss is occurring. Keep in mind that this tax revenue really shouldn't be seen as a surplus to anybody. It's not a benefit. It's simply a redistribution of income, meaning the government is collecting it, and they are going to then use it in another area.
So now we have supply shifting to the right. Because what a subsidy does is, it pays a producer to supply something. That's going to lower their cost of production, or give them just money to produce it. So they will, in fact, produce more. Quantity increases to Q2. So if Q1 and P star were the initial price and quantity, the price consumers pay is lower. OK. With the increase in supply price drops.
And the price that producers receive is up here, because the vertical distance between supply is now the amount of subsidy. So even though consumers pay a lower price, the producers are actually receiving a much higher price. What we want to keep in mind is that the subsidy being paid represents tax revenue that had to be collected somewhere else. So again, we'll be talking about that in a couple of slides.
All right, if we were to look at the welfare analysis here, this may seem a little bit confusing at first, because before, producer surplus was on the bottom and consumer surplus up top. But here, I'm showing you the new consumer surplus that's picked up from this, and the new producer surplus. Consumers are paying that lower price, so they actually gained this area here in consumer surplus. Producers are receiving this higher price. So they now picked up this area that they didn't have before in new producer surplus. And that's great.
However, there is, essentially, negative tax revenue. There is a cost to providing this subsidy, and that's represented by this area here. OK. That cost that is not going to either the producer or the consumer is the deadweight loss to society resulting from this. Again, keep in mind that the tax revenue required to pay out the subsidy has to be collected in some other market.
OK. So just because there's a deadweight loss does not necessarily mean that all taxes are, quote, unquote, "bad." What we need to keep in mind is that the impact in one market can certainly have impacts other markets. So let's talk about the deadweight loss that results in the cigarette market when we tax them.
Certainly, there is that deadweight loss. But now that we're taxing cigarettes, that's going to increase clean air. OK. If we did a little cost benefit analysis, let's say that the cost impacts a relatively small number of people-- the smokers-- but the benefits will certainly impact a much larger group of people, if we think about in terms of clean air. So if we do cost benefit analysis, it might not necessarily be bad, even though there is a deadweight loss in the cigarette market.
Likewise, when we tax things like alcohol and gambling, we see a reduction in those activities. And so it's going to have an impact on drinkers and gamblers, and they might not be so happy about it, but it can create a much more pleasant environment for people living in an area. We can see a reduction in crime, we can see less traffic. You can see left public drunkenness, for example.
So again, if we do some cost benefit analysis, we might actually see that the benefits outweigh the costs for the people engaging in these activities. Also the taxes might actually be used to benefit others by maybe going to public education, or something like that. OK.
We cannot see all of this on a graph. It it's hard to quantify. It is hard to measure, in terms of consumer and producer surplus and deadweight loss. So just keep that in mind as we're going through this analysis. The same idea goes for the deadweight loss in subsidies. Just because consumers and producers gain all of that surplus that I showed you, it doesn't necessarily mean the subsidies are all good.
There's always an opportunity cost with everything, and the same goes for subsidies. So for example, if we're going to go and subsidize dairy farmers to produce more milk, they might be very happy about that. We might be happy about it, in terms of our milk prices, but there might be higher prices, then, for other crops.
There might be higher taxes. The tax revenue is needed to provide the subsidy. So we're going to pay for this someway, somehow. If we do a cost benefit analysis, it might really only benefit a small number of farmers, compared to a large cost to society overall. So let's talk about the purpose of taxes.
One purpose is certainly to collect revenue for the government. Must people would argue that's the main purpose of taxes. But some people say that another purpose could be to modify consumer behavior, especially with things like cigarettes and alcohol. They put a lot of taxes on things like cigarettes and alcohol. And this can be to discourage the consumption of these things.
What we want to note here is that typically, it's only really effective initially. So at first, it might be effective in discouraging drinking or smoking, for people who really are truly addicted. These people might say, oh, you know, now that they're going to tax them so much, yeah, I'll give it up. I was thinking about giving it up, anyway. But eventually, higher and higher and higher taxes are really only going to cause consumers to alter their spending behavior to continue purchasing, because we're getting into people who are really addicted, and they're just going to continue purchasing anyway.
So in this tutorial, we looked at the effect of a tax on consumers and sellers, the effect of a subsidy on consumers and sellers. And we talked about how to use a welfare analysis to discuss the impact of taxes and subsidies, seeing what happens to consumer, producer surplus, and deadweight loss. Thanks so much for listening. Have a great day.
Determined by the difference between actual price paid for a good and the highest amounts the consumer would have paid for the good.
The difference between actual payment for a good and the least amounts a producer would have agreed to receive for the good.
A variable that decreases the producer and consumer surplus due to a section of an incapacitated resource, such as tax.