The analysis of welfare economics is built around the concept of Pareto efficiency. However, this efficiency criterion does not always represent a satisfactory answer. Other times, certain optimality conditions cannot be satisfied, and therefore Pareto efficiency simply cannot be reached. In order to solve this problem, and to find a new way to establish which allocation is best, economists have been since searching for new criteria to make a more informed decision.
In this Learning Path we’ll learn about some of these criteria, in order to understand them and being able to use them. In this LP we’ll learn about:
Second best, a theory by economists Kelvin Lancaster and Richard Lipsey.
Pareto efficiency
Summary
The analysis of welfare economics is built around the concept of Pareto efficiency. However, this efficiency criterion does not always represent a satisfactory answer. In order to solve this problem, and to find a new way to establish which allocation is best, economists have been since searching for new criteria to make a more informed decision. In this Learning Path we learn about some of these criteria.
his efficiency criterion was developed by Vilfredo Pareto in his book “Manual of Political Economy”, 1906. An allocation of goods is Pareto optimal when there is no possibility of redistribution in a way where at least one individual would be better off while no other individual ends up worse off.
A definition can also be made in two steps:
-a change from situation A to B is a Pareto improvement if at least one individual is better off without making other individuals worse off;
-B is Pareto optimal if there is no possible Pareto improvement.
This can be easily understood using an Edgeworth box. Starting from point C, two Pareto improvements can be made:
-from C to D: individual 1 would increase its utility, since a further indifference curve would be reached, while individual 2 will remain with the same utility;
-from C to E: individual 2 would maintain its utility while individual 2 increases theirs.
Once we are at point either D or E, no further Pareto improvements can be made. Therefore, D and E are Pareto optimal.
Following the same steps for every indifference curve, we can say that every point in which indifference curves from different individuals are tangent is Pareto optimal. The curve that links these infinite Pareto optima is called the contract curve.
Video – Edgeworth box:
Pareto efficiency is great, no doubt about it, but sometimes it is impossible to reach. That’s why we need other compensation criteria. Next, we’ll see a definition of compensation criteria: what they are, how they work, and what to expect of them.
Compensation criteria
In welfare economics, compensation criteria or the compensation principle is known as a rule of decision for selecting between two alternative states. Two states will be compared; if one state provides an improvement for one part but causes deterioration in the state of the other, it will be chosen if the winner can compensate the loser’ losses until they situation is at least as good as in the initial situation. However, this compensation may not necessarily occur.
This neo-Paretian concept was developed in order to solve the dead end in which the Pareto criterion was at the moment due to its limitations. Although, in essence, the compensation principle reduces to the Pareto criterion, it values positively a wider set that allows a positive ordering without transgressing the Pareto optimal.
To this day there has not been yet a unique and definitive compensation criterion due to its limits and some of its paradoxical implication; on the contrary, a great number of similar criterions have been formulated. From them we must highlight:
The Kaldor criterion is a compensation criterion developed by Nicholas Kaldor in his paper “Welfare Propositions of Economics and Interpersonal Comparisons of Utility”, 1939. This criterion is satisfied if state Y is preferred to state X and there is such a compensation and reassignment that Y turns to Yˈ that is at least as good as X in a Pareto sense. In the following graph we consider the utility of two individuals (A on the x-axis and B on the y-axis), which we will compare using the utility possibility frontier of two different moments.
When moving from state X to Y, individual A’s utility decreases, while individual B’s increases. Individual B is willing to compensate individual A and move to Yˈ where both increase their initial utility. The opposite, moving from Y to X, can also occur if the winner, this time individual A, compensates the looser, individual B, and is willing to relocate to Xˈ.
When moving from state Y to Z, the utility of individual A decreases, while individual B’s increases. Individual B is willing to compensate individual A and go to Zˈ where both increase their initial utility. On this case the opposite, moving from Z to Y, would not be feasible.
Tibor Scitovsky pointed out some inconsistencies and the consequent limitations of this criterion which are known as the Scitovsky paradox. This paradox is centred in the phenomenon that while Y can be preferred to X the opposite can also be true, as it was previously explained. This does not give a truly asymmetric result as it could just mean that going back to the initial situation is preferred. Economy would therefore oscillate between both points.
Hicks’ criterion
The Hicks criterion is a compensation criterion developed by John Richard Hicksin his paper “The Valuation of the Social Income”, 1940. It is similar to that of Kaldor’s, with different implications although with the same limitations. In this criterion, state Y is preferred to X, if there is not a potential reassignment that turns X into Xˈ, that is at least as good as Y in Pareto terms. In the following graph we consider the utility of two individuals (A on the x-axis and B on the y-axis), which we will compare using the utility possibility frontier of two different moments.
When moving from state X to Y, individual A’s utility decreases while it increases for individual B. Due to this, individual A should compensate individual B so the change of states does not happen, going from X to X’, which will increase B’s utility as much as going from X to Y, while the drop in A’s utility would not be as large. The same would happen if moving from Y to X. Since this ex-ante compensation is possible, neither X is preferred to Y nor Y will be preferred to X.
When moving from state Y to Z, again individual A´s utility decreases while it increases for individual B. When going from Y to Z, there is no possible compensation from individual A to individual B, since to the left of Y the utility possibility frontier is always higher. Individual A therefore can not compensate individual B, so Z is preferred to Y in Hicks’ terms. However, when comparing movement from Z to Y, the opposite logically occurs. Individual A’s utility increases while individuals B’s decreases. Individual B would compensate individual A going from Z to Z’ , and hence Y is not preferred to Z.
If we compare this with Kaldor’s criterion we see some significant changes but still both criteria fall under the Scitovsky paradox. This paradox is centred in the phenomenon that while Y can be preferred to X the opposite can also be true. This does not give a truly asymmetric result as it could just mean that going back to the initial situation is preferred. The economy would therefore oscillate between both points.
Some inconsistencies appear when using both Kaldor’s and Hicks’ criteria, known as the Scitovsky paradox. In order to solve it, we use what is known as Scitovsky’s criterion.
Scitovsky’s criterion
The Scitovsky criterion was developed by Tibor Scitosky in his paper “A Note on Welfare Propositions in Economics”, 1941, in order to solve the inconsistencies, -known as the Scitovsky paradox-, that Nicholas Kaldor’s and John Richard Hicks’ criteria presented. In order to solve these inconsistencies, he required the fulfilment of both criteria simultaneously. As an example, let’s analyse the following graph, where we consider the utility of two individuals (A on the x-axis and B on the y-axis), which we will compare using the utility possibility frontier of two different moments.
Kaldor’s criterion is met when going from X to Y, Y to X or Y to Z, but not when going from Z to Y. However, Hicks’ criterion is only met when going from Y to Z. Therefore, when comparing state Y to Z, winners can compensate the loss of the losers, but losers cannot compensate the other part in order to avoid the change. This is the only case in our example where the Scitovsky criterion is met, making Z preferred to Y.
Scitovsky considered the possibility of changes in Pareto terms caused by state changes. This justified the dual requirements. Analytically,
Although this criterion brings some positive contributions, there are still only minor changes that furthermore need to meet conditions. The estimation of a potential Pareto improvement is yet to be answered. Nevertheless, the Scitovsky criterion contributes to an intransitive organisation of different states
Little’s criterion
The Little criterion was developed by Ian M.D. Little in his paper “A Critique of Welfare Economics”, 1949, and it constitutes a further step for compensation principle theory. Little criticises the separation between efficiency and distribution and he demands as in Scitovsky’s criterion, for the Kaldor’s and Hicks’ criteria to hold. Furthermore, this criterion also requires that the income distribution is not worsened by the change of states.
This criterion however, brings some limitations, as a result of its implicit value judgement. The criterion will be met, if by a change of states the positively affected individual (winner) is poorer than the negatively affected individual (loser). As an example, let’s analyse the following graph, where we consider the utility of two individuals (A on the x-axis and B on the y-axis), which we will compare using the utility possibility frontier of two different moments.
Kaldor’s criterion is met when going from X to Y, Y to X or Y to Z, but not when going from Z to Y. However, Hicks’ criterion is only met when going from Y to Z. Therefore, when comparing state Y to Z, winners can compensate the loss of the losers, but losers cannot compensate the other part in order to avoid the change. This is the only case in our example where the Scitovsky criterion is met, making Z preferred to Y. However, Little’s criterion is only met if individual B is poorer than individual A.
Samuelson’s criterion
The Samuelson criterion, sometimes referred to as the Samuelson condition, was raised by the economist Paul A. Samuelson in his paper “Evaluation of Real National Income”, 1950, and belongs to the theory of welfare economics and used as a condition for the efficient provision of public goods. This critique provides a way to avoid intransitivity problems: state X will be preferred to Y if the alternative of X, X’, is preferred to the alternative of Y, Y’.
This criterion however, brings some limitations, since it is very similar to Pareto optimality. Samuelson explains that previous compensation criteria, such as Kaldor’s, Hicks’ or Little’s, hold just because they consider partial redistribution.
Now that we know everything we need about compensation criteria, let's learn about another way to avoid looking for Pareto optimality: Lancaster and Lipsey's Second Best theory.
Second best
Kelvin Lancaster and Richard G. Lipsey, in their article “The General Theory of Second Best”, 1956, following an earlier work by James E. Meade, treated the problem of what to do when certain optimality conditions (which must be considered in order to arrive at a Paretian optimum solution in a general equilibrium system) cannot be satisfied. The main idea in this article is that, when a constraint prevents the fulfilment of one of these conditions, the other conditions are in general no longer desirable. The optimum situation in this case can be attained only by neglecting the other conditions. Indeed, this new optimum is called “second best” because a Paretian optimum cannot be attained.
This can be easily understood using the diagram depicted in the article. We start by considering a typical optimization problem, with a given production possibility frontier (PPF) considered as a boundary condition, indifference curves (green curves, in this case representing a welfare function, ω) and the optimum where the PPF is tangent to ω (point P). Since this points lies on the transformation line and an indifference curve, it defines the production and consumption optima.
When we draw a new constraint condition (red curve), it can be easily seen that point P is no longer attainable. Q could be a second best solution, since it lies both on PPF and NewCC. However, as the authors point out, the second best point would be R, inside the transformation line. This is so because an improvement on welfare can be attained by moving to point R, since it lies on a further indifference curve (ω’’), and therefore means higher welfare.
The segment MN is technically more efficient than R, but since the points on this segment cannot be attained, R is the second best solution.
In this Learning Path we've learned about compensation criteria, used in order to avoid looking for Pareto efficiency when none can be reached. We've seen how Kaldor's and Hicks' criteria work well, except when Scitovsky's paradox appear. We've also learned about Little's and Samuelson's criteria, which keep in mind redistribution of wealth. Finally, we've seen how Lancaster and Lipsey's Second Best theory works.
“Photovoltaik Dachanlage Hannover” by AleSpa on commons.wikimedia.org is licensed under CC BY-SA
THE POLICY QUESTION SHOULD THE FEDERAL GOVERNMENT SUBSIDIZE SOLAR POWER INSTALLATIONS?
In 2006, in an effort to spur the use of solar power in the country, the US government created a solar investment tax credit (SITC) allowing US households and businesses to deduct 30 percent of the amount they invested in solar power installations. Since the program began, the growth rate in solar installations has been 76 percent per year.
The program has been seen as very successful in promoting solar energy installations. But what does economics say about the trade-offs of subsidizing these types of installations? Does the economic welfare they provide justify their costs?
This chapter looks at a method for evaluating the effects on price and quantity equilibriums when supply or demand—or both—changes within a market. Subsidies are just one potential cause of such changes. We will also look at the effects of taxes, price floors, and price ceilings. And throughout we will focus on the significance of changes in supply and demand for overall economic welfare.
11.1 CHANGES IN SUPPLY AND DEMAND
Learning Objective 11.1: Describe the causes of shifts in supply and demand and the resulting effects on equilibrium price and quantity.
The competitive market supply-and-demand model is one of the most powerful tools in economics. With it we can predict the impact of economic changes on consumers’ consumption decisions, producers’ supply decisions, and the market itself. We call the analysis of such changes comparative statics: the analysis of how equilibrium prices and quantities change when other exogenous variables—variables that shift demand and supply curves—change. The term static emphasizes the fact that we are comparing two different market equilibriums at discrete points in time—one before and one after the changes occur—as opposed to analyzing the dynamic process of price and quantity changes.
Changes in Demand
Since we know where supply and demand curves come from, we know precisely what can cause them to shift. Let’s start with demand. Recall the consumer choice problem: consumers want to maximize their individual utilities by choosing bundles of goods available to them in their budget sets. How do these bundles change? Price is one of the main mechanisms, but this is accounted for in the curve itself. As price falls, demand increases and vice versa—this is what the slope of the demand curve represents. But how do other factors affect demand?
A change in income.
It will shift the budget line and cause changes in quantities demanded. For example, if a tax refund causes consumers to demand more automobiles, the demand curve shifts to the right.
Changes in preferences.
They can alter the ultimate quantity choice. For example, a new study that finds negative health effects of drinking coffee could lower the demand for coffee, which would be reflected in a shift of the demand curve to the left.
Changes in the prices of goods that are substitutes or complements.
This can also affect the demand for a good. For example, if the price of Coca-Cola increases, the demand for Pepsi Cola might increase, causing a rightward shift in the demand curve.
Figure 11.1 shows the effect on price and quantity equilibriums when demand increases, and figure 11.2 shows the effect when demand decreases.
Figure 11.1 Increase in demand causes equilibrium price and quantity to rise.
Figure 11.2 Decrease in demand causes equilibrium price and quantity to fall
Changes in Supply
Shifts in supply arise from changes in the following:
The cost of production for the firms.
For example, autoworkers in the United States represented by a union might negotiate a new labor contract for higher wages. This represents a cost increase on the part of firms and will result in a leftward shift of the supply curve.
Technology that affects the production function.
For example, a new robotic technology that aids in the assembly of automobiles in the factory could improve the efficiency of the plant, resulting in a rightward shift of the supply curve.
The number of sellers in the market.
For example, perhaps a new company, like Tesla, decides to begin to manufacture cars in the United States, or a foreign company, like FIAT, begins to sell in the US market—either way, the number of sellers has increased, and the number of cars for sale is likely to increase as well, leading to a rightward shift in the supply curve.
The presence of alternative markets for sellers.
For example, an economic boom in Canada might cause US auto manufacturers to send more of the cars they produce to Canada instead of selling them in the United States, leading to a lower supply of cars in the US market represented by a leftward shift in the supply curve.
Figure 11.3 shows the effect on price and quantity equilibriums when supply decreases, and figure 11.4 shows the effect when supply increases.
Figure 11.3 Decrease in supply causes equilibrium price to rise and quantity to fall
Figure 11.4 Increase in supply causes equilibrium price to fall and quantity to rise.
Changes in Both Supply and Demand
To see what happens when both supply and demand change, let’s consider an example of each individually and then combined. On the demand side, a tax refund increases consumers’ incomes and results in an increase in demand for automobiles. The rightward shift in the demand curve will lead to a new equilibrium price and quantity. Compared to the original equilibrium price and quantity, the new equilibrium is characterized by higher prices and greater quantity.
On the supply side, we might have a situation of increased productivity resulting from the introduction of new robotic technology in automobile manufacturing. This would shift the supply curve to the right. Compared to the old equilibrium price and quantity, the new equilibrium price is lower and the new equilibrium quantity is greater.
What if both changes occurred at the same time? Both the demand curve and the supply curve would shift to the right. The effect on equilibrium quantity is clear: the new quantity would be greater than the original quantity, as both shifts move the quantity in the same direction. The effect on equilibrium price is ambiguous, since the demand shift puts upward pressure on price and the supply shift puts downward pressure on price. In the end, the actual change is the net of these two effects and will depend on the shape of the two curves and the magnitude of the two shifts. Figure 11.5 illustrates the situation where price rises, and figure 11.6 illustrates the situation where price falls.
Figure 11.5 Increase in demand and supply that causes equilibrium price and quantity to rise
Figure 11.6 Increase in demand and supply that causes equilibrium quantity to rise and price to fall
Similarly, for a simultaneous demand and supply decrease, quantity would unambiguously fall, but the effect on price will depend on the magnitude of the shifts, so without more information, we cannot predict the direction of the change.
What happens when supply and demand changes are in opposite directions? Figure 11.7 illustrates the situation when demand increases and supply falls. In this situation, the change in price is unambiguous—it will rise—but the effect on quantity depends on the relative magnitude of the shifts in the curves. Quantity can rise, fall, or remain unchanged. In figure 11.7, the quantity increases slightly.
Figure 11.7 Increase in demand and decrease in supply cause equilibrium price to rise and have an ambiguous effect on quantity
To summarize, when one curve moves and the other doesn’t, we can make predictions about the direction of the change in both price and quantity. When both curves move, we can make predictions about the direction of the change in one but not of both price and quantity. Table 11.1 summarizes the effects on price and quantity for changes in demand and supply.
Calculating and Comparing the New Market Equilibrium
So far, we have not considered the magnitude of the changes in equilibrium price and equilibrium quantity due to shifts in supply and demand. Without knowing the specific demand and supply functions, it is impossible to determine the precise magnitudes. With specific supply and demand functions, however, we can perform comparative statics analyses by solving for the original and the new equilibrium price and quantity and comparing them.
Let’s return to the demand and supply functions from chapter 10:
QD1=1,800−20P
QS1=50P−1,000
In chapter 10, we solved these and found the equilibrium price of $40 and the equilibrium quantity of one thousand.
Now suppose two things happen. One, some new information causes demand to increase. The new, higher demand is now described by the demand function:
QP2=2,400−20P
Two, a new manufacturing process increases the productivity of firms, resulting in an increase in supply. The new increased supply is described by the supply function:
QS2=50P−400
Solving for the new equilibrium, we get
2,400−20P=50P−400
2,800=70P
PS2=$40
Q∗2=1,600
Comparing these to the original equilibrium price and quantity reveals that quantity increased by six hundred and that price remained at $40. From table 11.1, we expected the quantity to increase, but we could not predict the direction of the change in price. For this specific example, we see that price has not changed. The graphical model is useful in making predictions about the directions of some equilibrium price and quantity changes, but we need a specific model in order to pin down the magnitude of changes in both price and quantity.
11.2 WELFARE ANALYSIS
Learning Objective 11.2: Apply a comparative static analysis to evaluate economic welfare, including the effect of government revenues.
We can apply the principles of comparative static analysis to measuring economic welfare. In chapter 10, we looked at welfare in terms of consumer surplus, producer surplus, and their combination, total surplus. For purposes of evaluating overall economic welfare, the total surplus is what economists care about. So we measure the effect of changes in supply and demand on welfare by comparing the total surplus before and after the change.
Figure 11.8 illustrates the change in welfare from an increase in demand. Increased demand leads to more transactions and to more consumer and producer welfare from all transactions. The blue-shaded area shows the net increase in welfare that results from the increased demand.
Figure 11.8 Increase in total welfare from an increase in demand
Predicting the effect on total welfare is straightforward when one curve shifts but complicated when both curves shift. Any increase in only supply or demand will increase total welfare, and any decrease in only supply or demand will decrease total welfare. It is also easy to see that welfare will increase when both supply and demand increase and will decrease when both supply and demand decrease. But what happens when one increases and the other decreases?
Figure 11.9 shows a situation where demand increases at the same time that supply decreases. The blue triangle represents the original total welfare, the red triangle represents the new total welfare, and the purple triangle represents neither a gain nor a loss in welfare. Whether there is a net gain or loss in welfare depends on the relative sizes of the areas marked “gain in welfare” and “loss in welfare.” As is easy to see, whether this is a net loss or gain depends on the magnitude and position of the shifting curves and can easily go either way.
Figure 11.9 Welfare effects of shifts in both curves
Sometimes the government takes actions that lead to positive government revenue (e.g., imposing a tax) or negative government revenue (e.g., spending money). Economists account for government revenues or expenditures by including them in the total surplus calculations. Government revenues are public resources and spending is with public money, so both should be accounted for the same way consumer and producer surpluses are—they are all part of the societal gains or losses that we consider in total surplus:
Note that government revenue can be positive (tax receipts) or negative (government spending).
11.3 PRICE CEILINGS AND FLOORS
Learning Objective 11.3: Show the market and welfare effects of price ceilings and floors in a comparative statics analysis.
Price ceilings and price floors are artificial constraints that hold prices below and above, respectively, their free-market levels. Price ceilings and floors are created by extra-market forces, usually the government. A classic example of a price ceiling is a rent-control law like those that exist in New York City. Figure 11.10 illustrates the effect of a price ceiling in a market for rental housing. The price ceiling holds prices below the market equilibrium price, and there are more consumers wishing to rent apartments at the ceiling price than there are rental units available. The result is excess demand for rental housing.
Market equilibrium price is sometimes referred to as the market-clearing price. This term references the fact that the market is cleared of all unsatisfied demand and excess supply at the equilibrium price.
Figure 11.10 Welfare effects of a price ceiling
The effect of a rental price ceiling on welfare is clear. Fewer apartments will be rented than at the market equilibrium price, and all the surplus that would have been created by those rentals is not realized, resulting in deadweight loss. Of the total surplus that is created, a greater proportion accrues to the consumers than the producers, but in welfare terms, only the total surplus matters. So price ceilings do two things:
They lower total surplus and create deadweight loss.
By creating excess demand, they create winners and losers among consumers. In the case of a rental price ceiling, some consumers are lucky enough to find an apartment to rent at the ceiling price, while others cannot.
The consumer surplus shown in figure 11.10 assumes that the market will somehow allocate the apartments to the users whose valuation of them is the highest (those that represent the highest points on the demand curve). But no mechanism exists to assure that this will happen. Instead, there is likely to be a random assignment of apartments among those willing to pay the ceiling price. This means that figure 11.10 likely overstates the resulting consumer surplus and understates the deadweight loss. We will continue with the assumption of efficient allocation of apartments to keep the analysis simple, but it is important to understand the consequences of this assumption.
Figure 11.11 illustrates the situation for a price floor. When the price of a good is not allowed to sink to its market equilibrium level, a situation of excess supply occurs where producers would like to make and sell more goods than customers would like to buy. The price floor creates a deadweight loss in the same way a price ceiling does: it limits the number of goods that are bought and sold and therefore limits the amount of surplus created relative to the potential surplus. In the case of the price floor, more of the surplus that is created is in the form of producer surplus than consumer surplus. An example of a price floor might be the regulated fares for taxis in many cities. The success of Uber and Lyft, so-called ride-sharing services, suggests that there is indeed an excess supply of potential taxis that would be quite happy to give rides for less.
This analysis assumes that firms with the lowest marginal cost supply the good, but there is nothing in the market that ensures this. So the true welfare effects are likely to be lower producer surplus and higher deadweight loss than depicted in figure 11.11.
Figure 11.11 Welfare effects of a price floor
For both price ceilings and price floors, the welfare impact is clear: there is a reduction in total surplus relative to the market equilibrium price and quantity.
11.4 TAXES AND SUBSIDIES
Learning Objective 11.4: Show the market and welfare effects of taxes and subsidies in a comparative statics analysis.
Governments levy taxes to raise revenues in many areas. Governments at all levels—national, state, county, municipality—tax things such as income, hotel rooms, purchases of consumer goods, and so on. They tax both producers of goods and consumers of goods. Governments also subsidize things, such as the production of dairy goods or the purchase of electric cars. In this section, we will explore how taxes and subsidies affect the supply-and-demand model and the impact of supply and demand on welfare. We will discover that it does not matter upon whom you levy a tax or to whom you provide a subsidy, producers or consumers; the burden or benefits will end up being shared among producers and consumers in identical proportions.
Taxes on Sellers
To examine the effects of a tax on a market, let’s perform a comparative static analysis. We will start with a market without a tax and then compare it to the same market with a tax. Let’s consider the market for tomatoes at the farmers’ market in Lawrence, Kansas. The current equilibrium price is $1.00 per tomato, and the equilibrium quantity is five hundred. Now suppose that the city of Lawrence decides it needs to raise revenues to support the improvement of infrastructure at the market and imposes a sales tax on tomatoes to do so. What would be the impact of this tax on the market?
A sales tax on tomatoes can be imposed on either buyers or sellers. Generally, sales taxes are collected by sellers and then remitted to the government. This means that for a $1 tomato that has a 10 percent tax, the seller collects both the $1 and the $0.10 for the government. We call this type of tax an ad valorem tax because it depends on the value of the good itself. Alternatively, the government could have imposed a set amount, like $0.20, on one tomato, regardless of the price of the tomato itself—this is known as a specific tax. For this analysis, we will use a specific tax because it is easier to analyze, but either way, the analysis is similar. So let’s consider a $0.20 tax on each tomato to be paid by sellers. Since the seller collects the tax, we can illustrate its effect on the market through the supply curve.
Consider any single point on the supply curve. This point is the seller’s willingness-to-accept price for a tomato at a certain supply quantity. Suppose this price is $0.50 at a given point. If the government imposes a $0.20 tax on each tomato, the seller’s new willingness-to-accept price will rise to $0.70. This price is the sum of the original willingness-to-accept price and the $0.20 that the seller will collect from the buyer and give to the government. The same logic applies to every point on the supply curve, so the tax has the effect of creating a new supply curve shifted upward by $0.20 from the original supply curve. Figure 11.12 shows the original supply curve (S1) and the shifted supply curve (S2).
Figure 11.12 Effect of a tax on sellers of tomatoes at the Lawrence farmers’ market
The original equilibrium price of a tomato is $1. With the new tax, there is a difference between what consumers pay and what producers receive—the difference being the $0.20 tax per tomato. So equilibrium price is no longer a single value at which quantity supplied is equal to quantity demanded. Now in order for the market to be in equilibrium, the quantity demanded at the price consumers pay, which includes the tax, must equal the quantity supplied at the amount the sellers receive after the government takes out the tax.
Figure 11.12 shows the new equilibrium. For now, don’t worry about where the prices and quantities come from; we will take them as given. In figure 11.12, the new equilibrium quantity is shown as 450, the price paid by consumers is $1.10, and the price received by producers is $0.90. The consumer surplus was A+B+E but is now only A, and the producer surplus used to be C+D+F but is now only D. The revenue generated by the government from the tax on tomatoes is the area B+C. The tax creates a deadweight loss from the reduction in sales, and the deadweight loss is E+F. Total surplus includes consumer surplus, producer surplus, and government revenue: A+B+C+D. What policy makers must decide in general is whether the objectives achieved by the tax are worth the loss in efficiency represented by the deadweight loss, E+F.
Taxes on Buyers
Suppose the city of Lawrence decided to collect the $0.20 tax from consumers as they left the farmers’ market. For example, there might be a person with whom you have to check out as you leave, and this person counts your tomatoes and charges you the $0.20 per tomato. How does this scenario change the graphical analysis?
Since the value to the consumer of a tomato has not changed, the willingness to pay remains the same. Thus a consumer that was willing to pay $1 for a tomato is still willing to do so, but $0.20 of that $1 now goes to the city. So in essence, the consumer was willing to pay the farmer $1 for the tomato but is now only willing to pay the farmer $0.80. This is represented by the blue demand curve (D2) in figure 11.13, which is the same as the previous demand curve but lowered by $0.20, or the amount of the tax.
Figure 11.13 Effect of a tax on buyers of tomatoes at the Lawrence farmers’ market
The effect on the new market equilibrium of a tax on buyers is identical to the effect of the tax on sellers. The tax itself creates a wedge between what buyers pay and what sellers receive, and the new equilibrium quantity is the same as before. Consumer surplus, producer surplus, government revenue, and deadweight loss are all the same as before. The lesson here is that it makes no difference on whom the government levies the tax; the tax does not stay where the government puts it. In this example, whether the tax is applied to the consumer or the seller, the consumer pays $0.10 more than without the tax, and the seller receives $0.10 less than without the tax.
Distribution of the Tax Amount
In our tomato tax example, the tax amount is shared equally between the sellers and buyers ($0.10 each), but is this always true? The answer is no. How much of the tax burden falls on buyers and sellers depends on the elasticities of the supply and demand curves. The following figures illustrate this concept. Figure 11.14 shows a relatively elastic demand curve with a relatively inelastic supply curve. The original pre-tax equilibrium price is P1, the post-tax price buyers pay is PB, and the post-tax price sellers receive is PS. In this case, the greater share of the burden of the tax falls on sellers, as can be seen by the fact that P1−PS>PB−P1. We call the division of the burden of a tax on buyers and sellers the tax incidence.
Figure 11.14 Tax incidence with inelastic supply and elastic demand
In figure 11.15, the supply curve is relatively elastic, the demand curve is relatively inelastic, and the majority of the tax incidence falls on the buyers, as can be seen by the fact that PB−P1>P1−PS.
Figure 11.15 Tax incidence with elastic supply and inelastic demand
These tax-sharing effects make sense intuitively if we think about the meaning of elasticity. A more elastic curve means a larger quantity response to a change in price. Only a small part of the tax burden can be given to market participants that are more responsive to price and a larger part can be given to those that are less responsive to price because the quantity demanded and supplied must equal in the end.
Subsidies for Buyers
The effects of subsidies on markets are similar to taxes in that they create a difference between what consumers pay and what suppliers receive. They are also similar in that it does not matter if you subsidize the purchase of a good or the sale of a good; the market equilibrium effects are the same. In the next section, we’ll consider in more detail the market equilibrium effects of a government policy to subsidize buyers of solar power installations. For now, we’ll examine a simpler example to understand the mechanics of such a subsidy.
Let’s go back to the Lawrence farmers’ market. Suppose the city government decides that it is important to support the tomato growers. It will subsidize consumers in the amount of $0.20 for each tomato they purchase. Suddenly, potential buyers who would have bought a tomato if the price was $1 are now willing to buy a tomato that is priced at $1.20 because their out-of-pocket cost is the same. We can see this effect in figure 11.16. In the figure, the demand curve is shifted up by the amount of the subsidy leading to an increased quantity purchased, Q2, and an increased equilibrium price, PS.
Figure 11.16 Effect of a subsidy on tomatoes at the Lawrence farmers’ market paid to buyers
Tomato sellers are certainly helped by this policy. Producer surplus was C+D, and it is now B+C+D+E, so it has increased by B+E. Consumer surplus has also increased. Originally it was A+B. After the subsidy, it is A+B+C+F+G, so it has increased by C+F+G. To see this, remember that consumers are actually spending PC on each tomato. So both consumer and producer surpluses have increased.
The government spends $0.20 on each tomato sold, and Q2 are sold, so the cost to the government of this policy is shown as the area B+C+E+F+G+H.
And how does welfare change with the implementation of the subsidy? Within the area of government expense, B+E is the new producer surplus, and C+F+G is the new consumer surplus. That leaves only the area H as government expenditure not offset by the new surplus. Therefore, H is the area of deadweight loss, and net welfare has decreased by H.
Subsidies for Sellers
Suppose instead of giving $0.20 to buyers of tomatoes, the government gives it to the sellers of tomatoes. This subsidy is shown in figure 11.17 where the supply curve is shifted down by the amount of the subsidy. In this case, sellers who would have been willing to accept $0.70 for a tomato will now accept $0.50 for the same tomato because the government will give them the extra $0.20. The effect on the market with respect to consumer surplus, producer surplus, government expenditure, and deadweight loss is identical to the case where the subsidy is paid to the buyers.
Figure 11.17 Effect of a subsidy on tomatoes at the Lawrence farmers’ market paid to sellers
In fact, for both forms of subsidies, the true benefit is not the $0.20 paid by the government but the price paid by consumers relative to the price without the subsidy. So the consumer benefit is P1−PC. Similarly, the producer benefit is the difference between the new post-subsidy price and the pre-subsidy price, or PS−P1. The distribution of these benefits depends on the relative elasticities of the two curves, just as we saw with taxes.
11.5 THE POLICY QUESTION SHOULD THE FEDERAL GOVERNMENT SUBSIDIZE SOLAR POWER INSTALLATIONS?
Learning Objective 11.5: Apply a comparative static analysis to evaluate government subsidies of solar panel installations.
The SITC is a 30 percent federal tax credit to buyers of solar systems for residential and commercial properties. This credit reduces the federal income taxes that a person or company pays dollar for dollar based on the amount of investment in solar property.
We know from section 11.4 that the impact of a subsidy on a market does not depend on the designated receiver of the subsidy. In this case, the subsidy is paid to buyers of solar panels, both residential and commercial. What we need to properly analyze in this market is some notion of elasticity of the demand and supply for solar panels.
In general, studies have found residential energy usage to be fairly inelastic. This is because measures that consumers can take to save energy in response to price increases—like lowering the thermostat in winter and raising it in summer, turning off lights diligently, and using more energy-efficient lightbulbs—can only mitigate usage somewhat.
If this logic carries over to the solar panel market, the effect of the subsidy would look like figure 11.18. In this figure, the consumer surplus increases C+F+G, and the producer surplus increases B+E. It is clear from the figure that the larger share of the benefits from this policy accrues to consumers, but there is still a fair amount of deadweight loss, H. If the goal of the policy is to increase the consumption of solar panels, it has clearly succeeded, shifting consumption from Q1 to Q2.
Figure 11.18 Effect of the solar investment tax credit (SITC) program on the market for solar panels with inelastic demand
However, it is probably not the case that the market for solar panels is the same as the market for residential energy. This is because solar panels represent only one form of energy, and close substitutes such as electricity delivered from the power plant, natural gas, and propane exist and are easily accessible for most homeowners. So it is quite likely that consumers have demands for solar panels that are quite elastic, as small movements in price could alter the comparative calculus between solar and other forms of energy a lot. If this is true, then our market would look a lot more like figure 11.19.
While similar to figure 11.18, figure 11.19 is different in one crucial aspect. Our subsidy is likely to increase consumption more with an elastic demand curve than with an inelastic demand curve. It is also true that the increases in consumer and producer surplus are more equal and that there is still substantial deadweight loss.
Figure 11.19 Effect of the solar investment tax credit (SITC) program on the market for solar panels with elastic demand
Our analysis shows that the SITC is likely to be successful in increasing the consumption of solar panels, but it will also be quite costly and create a lot of deadweight loss. Is it worth it? To answer this question, policy makers have to evaluate the benefit to society of increased reliance on solar power and compare it to the cost of the program in terms of both accounting costs (B+C+E+F+G+H) and deadweight loss (H).
EXPLORING THE POLICY QUESTION
What other ways could the government sponsor the installation of solar energy systems, and how would their effects differ from a subsidy to buyers?
Do you support the SITC subsidy? Why or why not?
Results of adjustments to demand and supply graphs in a grid for comparison
