2-2.3. The Incidence of Taxation

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From the course by University of Illinois at Urbana-Champaign

Firm Level Economics: Consumer and Producer Behavior

445 ratings

University of Illinois at Urbana-Champaign

Firm Level Economics: Consumer and Producer Behavior

445 ratings

Course 1 of 7 in the Specialization Managerial Economics and Business Analysis

All goods and services are subject to scarcity at some level. Scarcity means that society must develop some allocation mechanism – rules to determine who gets what. Over recorded history, these allocation rules were usually command based – the king or the emperor would decide. In contemporary times, most countries have turned to market based allocation systems. In markets, prices act as rationing devices, encouraging or discouraging production and encouraging or discouraging consumption in such a way as to find an equilibrium allocation of resources. We will construct demand curves to capture consumer behavior and supply curves to capture producer behavior. The resulting equilibrium price “rations” the scarce commodity. Markets are frequent targets of government intervention. This intervention can be direct control of prices or it could be indirect price pressure through the imposition of taxes or subsidies. Both forms of intervention are impacted by elasticity of demand. After this course, you will be able to: • Describe consumer behavior as captured by the demand curve. • Describe producer behavior as captured by the supply curve. • Explain equilibrium in a market. • Explain the impact of taxes and price controls on market equilibrium. • Explain elasticity of demand. • Describe cost theory and how firms optimize given the constraints of their own costs and an exogenously given price. This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.

From the lesson

Module 2: Government Intervention in Markets

Markets are frequent targets of governments. This module will introduce government policy intervention into the market. This intervention can be direct control of prices or it could be indirect price pressure through the imposition of taxes or subsidies. Both forms of intervention are impacted by elasticity.

2-2.1. The Price You Pay at the Pump1:05

2-2.2. Excise Taxes10:00

2-2.3. The Incidence of Taxation5:46

Meet the Instructors

Larry DeBrock
Dean Emeritus and Professor of Finance and Professor of Economics
University of Illinois, Urbana-Champaign College of Business Department of Business Administration

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We modeled the impact of an excise tax on

a market.

The government comes in and imposes a per-unit tax on producers.

Gasoline was our model.

And one thing that we found was that the impact of the excise tax was to

increase cost, which basically made the supply curve shift up.

Or you can think of it shifting back towards the vertical axis.

Let's put our picture together with price on the vertical axis, and quantity,

in terms of gallons of gasoline, on the horizontal axis.

And we'll start with a demand curve that looks like this, D0, and

a supply curve that looks like this of S0.

And we said let's just start with a pre-tax

world of the price of gasoline being $2 per gallon.

And that many units of output is the equilibrium out in that market.

Now we impose a $1 per gallon excise tax per unit tax of $1 a gallon.

And if you were to ask most people, in fact, economists have done this,

taken polls of people.

And say, suppose the gasoline price is currently $2 a gallon and we're gonna

put a $1 a gallon gas tax on, what's gonna happen to the price of gasoline?

99% of the people polled on the street say it's gonna go up to $3.

It seems right.

If it's $2 now, if you add a dollar it's gonna go up.

But as we saw last time,

what happens because of the imposition of the tax is that the supply curve

after tax has gone up vertically by the size of the tax at any given output level.

And what that's means is that if this was $2, this cap is also $1.

And that means that in fact the equilibrium price which we'll say

here is 2.45 has not gone up by the full $3.

Its important that you recognize that while the consumers are paying 2.45,

this 1.45 is all the firm gets to keep.

The gasoline dealer before the tax, got to keep $2, which he or

she used to pay for their employees.

And now after the tax, the price has gone up to $2.45 a gallon for the customer.

But one green sheet of paper,

$1 from that has to go to the municipality who's imposed the tax, okay.

So this amount comes right off the top.

So the net that the firm retains,

which is $1 less than what the consumers shell out of their pocket, by definition.

That's what the tax does.

They drop that amount.

So economists have a term for this.

It's called the incidence of taxation.

And the incidence of taxation just says who pays what share of the tax.

In this case, you can see that consumers have $0.45 extra

in terms of what's coming out of their pocket.

So the consumer, the incidence on the consumer would be $0.45, and

the incidents on the firm would be, they are losing $0.55.

In this case the $1 gets spread between two groups.

The incidence of taxation is the term the economists use to say who bears what share

of that tax.

And the way we've drawn this,

it looks like consumers are getting off a little easy compared to firms.

The problem with this thing is, no problem, that's the right analysis,

but as you should start thinking about,

this really depends on the shapes of these curves.

So for example, let me draw another picture,

that hopefully will make this a little bit clear.

We'll put price in a vertical axis, and quantity on the horizontal axis, and

we'll have a supply curve that looks like this.

But as I talked to you about earlier, the demand curve for

gasoline is actually pretty steep.

When the price of gas goes up, consumers complain about it a lot.

They get mad and grumbled, but they still buy pretty much the same amount of gas.

There's some cutback.

Maybe they'll carpool now and then.

Maybe they won't take as many trips to the grocery store.

They'll try to plan their shopping trips more frugally than they would in the past.

But, in general, the demand curve for gasoline is pretty steep.

And what that means is, that if you were to look at the pre-tax situation,

which is the $2 gallon of gasoline, and Q0 gallons actually transacted in the market.

And now impose a $1 per gallon excise tax, we know what happens.

The supply curve will be shoved vertically by that $1 at any given output point.

So we connect these points.

This gap is the $1.

And of course this gap is also the $1.

Now look what's happened.

Equilibrium in this case has gotten a much higher price.

The new equilibrium price looks like it's about $2.95.

And the firms looks like what they get to retain,

cuz they have to give $1 up, they will retain $1.95.

So everything else being equal from my earlier picture, all I've done now was

to put a little bit more realistic steep demand curve in there.

And because of that steep demand curve, you see that in fact

the vast majority of the gasoline tax is passed right on to the consumer.

The vast majority in this free market equilibrium,

the way the market determines price, given the responsiveness to price from

the demand curve versus the supply curve, price is gonna go up quite a bit.

And in this case, the incidence of taxation would be $0.95 on consumers,

and on firms the incidence would be $0.05.

This difference between the previous picture and

this one is because of the shape of the demand curve.

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