Incidence of A Tax

Tax incidence refers to who actually pays the tax. Sellers may have the legal obligaton to pay the tax to the government but they try to pass it on to consumers in the form of higher prices. Consumers will pay a larger share of the tax in the form of higher prices if demand is inelastic. Sellers will pay a larger share if demand is elastic because the price increase will be small and ther reduction in the quantity sold (and thus profits) will be large.

Incidence, continued
The incidence of the tax also depends on the price elasticity of supply Other things being equal, the larger the price elasticity of supply, the more of the tax will be shifted to consumers in higher prices. When supply is price inelastic, more of the tax is paid by producers.

Subsidies

Subsidies are payments by the government to sellers (or buyers) based on how much they produce (purchase). Subsidies to sellers act like a reduction of costs. Sellers are willing to sell more at each market price. Equilibrium price falls and quantity increases. More of the subsidy is passed on to consumers in the form of lower prices if demand is inelastic than if demand is inelastic. Sellers get a larger share of the subsidy if demand is elastic as the fall in prices is small and the quantity of good sold (and profits) is large.

Why have taxes or subsidies?
Certain goods will not be provided by the market so government must provide for their production by using tax revenues. To correct for inefficiencies due to spillovers (external costs or benefits). Because people think the distribution of goods and services is unfair. As a consequence of power politics (rent seeking).

Characteristics of Public Goods

Non-rival (joint) consumption: one person's consumption of the good or service does not reduce the quantity available for others. Non-excludable: Impossible to exclude anyone from consuming the good. Everyone gets it whether or not they pay. Examples: National defense, law enforcement, species preservation Note: Not all goods and services provided by government agencies are public goods. Some which are not: education, city transit systems, information gathering.

Consequences

Because even those who don't pay will still receive the public good, people have an incentive to be free riders. As long as someone else pays, they'll get something they value (the public good) for free. Because even people who value the good won't pay, no private business can make a profit producing and selling the good. Even when consumers value some units at more than the opportunity cost, the goods are not produced. The market is not efficient as these beneficial transaction do not occur. The government can improve well-being by taxing people to provide for the good.

Example

Quantity of the public good A's value B's value C's value D's value Total Marginal Cost 1 4 5 5 3 17 6 2 3 4 4 2 13 7 3 2 3 2 1 8 8 4 4 1 2 0 0 3 9 No one person values the good enough to alone pay the cost of producing it. The optimal quantity is 3 units (total marginal benefits = marginal cost at 3). If the government taxes each person $5.25, the revenues ($21) would be sufficient to pay the cost of producing (6+7+8=21). Each person would be better off as each receives a total benefit from 3 units greater than $5.25.

Spillover Principle

A spillover or externality is a cost or benefit experienced by someone other than the person or organization that decides how much of the good to producer or consume. Examples of spillover costs (external costs) include air and water pollution, loud noise generated by production or consumption. Examples of goods whose consumption generates spillover (external) benefits include health care, education, research.

Coase Theorem

If transactions costs are low, the externality problem can be eliminated by assigning property rights. Those with rights can claim compensation for harm or those harmed can pay the owner to reduce the externality. In either case, the decision-maker now considers the external costs in deciding how much to produce or consume. Assigning property rights will not solve the externalities problem if One party's actions affect a large number of others because the costs of negotiating a solution are too high. Property rights can not be specified or enforce due to physical constraints or the cost of excluding those without rights.

Efficiency reduced

Because externalities can not always be eliminated through private actions, some external costs remain. If there are external costs, a competitive market will be inefficient because the marginal social (private plus external) costs of production of some units exceeds the marginal benefits of these units (their value to consumers). Too much is produced. Producing less of goods which pollute would free resources to produce more valuable alternatives. Government action can improve efficiency.

Government Action

Government calculates the efficient level of pollution: pollution should be reduced as long as the marginal benefits of reduction outweigh the marginal costs of abatement (marginal cost of equipment plus the value of lost output). Zero pollution may or may not be the most efficient level. As pollution is reduced, the marginal benefits of further reduction are small (the remaining pollution does little harm) and the marginal costs of abatement rise.

Government tools

The government can bring about the desired reduction in pollution in a number of ways Controls: government sets a standard for the maximum allowable pollution and orders each producer to comply. Taxes: The govenment taxes firms according to how much they pollute. Subsidies: The government can help firms reduce pollution by paying some of the costs of doing so. Permits: the government auctions permits to pollute. Permits may be resold but only those who have one of the limited number of permits may emit pollutants.