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

534 ratings

University of Illinois at Urbana-Champaign

Firm Level Economics: Consumer and Producer Behavior

534 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 Pump0:58

2-2.2. Excise Taxes9:54

2-2.3. The Incidence of Taxation5:39

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

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 the increase cost which basically made the supply curve shift upwards,

you could 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.

We'll start with a demand curve that looks like this,

D_0, and a supply curve that looks like this, of S_0,

and we said, let's just start with

a pretax world of price of gasoline being two dollars per gallon.

That many units of output is the equilibrium amount of that market.

Now we impose a one dollar per gallon excise tax per unit tax,

or a dollar a gallon.

If you would ask most people, in fact,

economists have done this,

taken polls of people and say,

"Suppose the gasoline price is currently two dollars a gallon and we're

going to put a one dollar a gallon gas tax on,

what's going to happen to the price of gasoline?"

Ninety-nine percent of the people polled on the street said,

"It's going go up to three dollars."

It seems right, now it was two dollars,

now if you add a dollar it's going to 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.

What that means is that if this was two dollar,

this gap is also one dollar,

and that means that in fact the equilibrium price,

which will say here is 2.45 has not gone up by the full three dollars.

It's 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 two dollars,

which he or she used to pay for their employees.

Now after the tax,

the price has gone up to $2.45 a gallon for the customer,

but one green sheet of paper,

one dollar from that has to go to the municipality who's imposed the tax.

So, this amount comes right up the top.

So, the net that the firm retains,

which is a dollar less than what consumers shell out of their pocket,

by definition that's what the tax does,

they've dropped 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 incidents on the consumer will be $0.45,

and the incidence on the firm will be they're losing $0.55.

In this case, the one dollar gets spread between two groups.

The incidence of taxation is a term that economists

use to say who bears what share of that tax,

and the way we've drawn this looks

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

The problem with this thing,

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 clearer.

We'll put price on the vertical axis and quantity on the horizontal axis.

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 gasoline goes up,

consumers complained about it a lot,

they get mad and grumbled but they still pretty much by the same amount of gasoline.

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 have in the passed.

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

What that means is that if you were to look at the pretax situation,

which is the two dollar gallon of gasoline,

and Q_0 gallons actually transacted in the market.

Now impose a one dollar per gallon excise tax,

we know what happens, the supply curve will be

shoved vertically by that one dollar at any given point.

So, we connect these points.

This gap is the one dollar,

and of course this gap is also the one dollar.

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,

because they have to give a dollar up,

they will retain $1.95.

So, everything else being equal for my earlier picture,

all I've done now is to put a little bit more realistic steep demand curve in there.

Because of that steep demand curve,

you see that in fact

the vast majority of the gasoline tax is passed right onto 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 going to 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 $0.5.

This difference between the previous picture and this one is

because of the shape of the demand curve.

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