Positive vs. Normative Economics: Taxation and Market Effects

Positive vs. Normative Economics

• Positive economics is independent of the ethical value system of the economist.
• Normative economics consists of statements in economics that reflect or are based on the ethical value system of the economist, implicitly, explicitly or by omission.

Efficiency

Consumer Surplus

In order to evaluate the economic impact of a policy, it is useful to have a notion of the economic gains buyers/sellers earn by trading in a market.

Definition: Consumer surplus: The difference between a buyer's reservation price and the price actually paid.

Example:

• 11 potential consumers
• Each consumer can buy one unit of the good
• The first potential buyer's reservation price is £11, the second buyer's is £10, the third buyer's is £9 et.

Consumer Surplus

12 - 11 10 9 Price (€/unit) 8 7 2 1 Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 Units/day

Consumer Surplus

12 - 11 Consumer surplus = €15/day 10 9 Price (€/unit) 8 7 5 4 3 2 1 Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 Units/day

Consumer Surplus

Consumer surplus Supply 3.00 Consumer Surplus = €2000/day 2.50 Price (€/litre) 2.00 1.50 1.00 0.50 Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity (1,000 litres/day)

Producer Surplus

Definition: Producer surplus: The difference between a seller's reservation price and the price received

Supply 3.00 2.50 Price (€/litre) 2.00 Producer surplus = €4,000/day 1.50 1.00 0.50 Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity (1,000 litres/day)

Total Economic Surplus (Total Welfare)

Total Economic surplus: Consumer Surplus + Producer Surplus In the previous example, consumer surplus = €2000/day; producer surplus = €4000/day. So, Total Surplus = €2000/day + €4000/day = €6000/day

Pareto efficient: no one can be made better off without making someone worse off.

• Competitive equilibrium: the benchmark of efficiency.
• Assumptions P Pareto Efficient supply Demand Q

Market Equilibrium and Efficiency

Assume:

• All benefits from consumption are captured by the demand curve
• All costs from production are captured by the supply curve
• Information
• Low transaction cost
• Perfectly competitive market

When this is true, the market equilibrium will be Pareto efficient - no one can be made better off without making someone worse off

Price Ceilings

Without price controls: Equilibrium Price = €1.40 Equilibrium Quantity = 3000 Consumer Surplus = €900 Producer surplus = €900 Economic surplus = €1,800

2.00 Consumer surplus = €900/day Supply 1.80 1.60 1.40 Producer surplus = €900/day Price (€/litre) 1.20 1.00 0.80 Demand 0 1 2 3 4 5 8 Quantity (1,000 litres/day)

Price Ceilings and DWL

Deadweight Loss (DWL): The reduction in total economic surplus. Consumers willing to pay just under €1.80 for an additional litre

2.00 Consumer surplus = €900/day Lost economic surplus = €800/day DWL 1.80 Supply 1.60 1.40 Producers willing to sell an additional litre for just over €1.00 Price (€/litre) 1.20 1.00 Price ceiling 0.80 Producer surplus = €100/day Quantity sold with price controls Quantity that would be sold without price controls Demand 0 1 2 3 4 5 8 Quantity (1,000 litres/day)

Price Floor Example

Labor Market - Minimum Wage

Suppose the government set minimum wage at £10.

w Supply Excess supply 10 8 E Demand L

Labor Market - Minimum Wage Impact

The government says the minimum wage is £10.

w (£/hour) Supply unemployment 10 8 E OWL Demand L 32 (hours)

Taxation and the Market for Beer

Example: Taxation and the market for beer. Without a tax, total surplus is €9 million/day.

à 6 Supply 5 4 CS Price (£/pint) 3 2 PS 1 Demand 0 1 2 3 4 5 Quantity (million pints/day)

Taxation and DWL

A £1 per pint tax is levied on beer sellers A tax increases the price to consumers but decreases the price received by sellers

S + tax 6 Supply (S) Price paid by consumers 5 GS 4 3.50 3 Tax Rey Price kept by sellers after paying the tax 2.50 2 PS 1 Demand (D) 0 1 2 2.5 3 4 5 Quantity (million pints/day) Price (£/pint) MO

Tax on Alcohol and Price Elasticity of Demand

Supply2 P Supply1 L P' E' Tax P E T Demand Q Q' Q

Supply2 P Supply1 E' PB P Tax E Ps Demand Q" Q Q

Tax on Alcohol and Tax Burden

Supply2 P Supply1 PB P E Tax Demand Ps Q" Q Q

Supply B C Price without tax = P1 E D Price sellers = Ps receive F Demand 0 Q2 Q1 Quantity Price buyers = PB pay A

Taxation and DWL Summary

Without Tax With Tax Change Consumer Surplus A +B +C A -(B + C) Producer Surplus D +E +F F -(D + E) Tax Revenue None B + D +(B + D) Total Surplus A+B+C+D+E+F A+B+D +F -(C + E) The area C + E shows the fall in total surplus and is the deadweight loss of the tax.