Microeconomics

Soumitra Ghosh
School of Health Systems Studies, Tata Institute of Social Sciences
The Costs or Economic Impact of Taxes

 Taxes are the most important method by which governments fund their activities.

 Analyse the effects of Taxes, how it affects welfare, economic wellbeing of people.

 We will look at per unit taxes (taxes assessed as a particular amount in rupees on the sale of a good
or service, as opposed to a percentage tax. For example, the government imposes taxes amounting to
Rs. 7 per 200 ml can of carbonated drinks such as Coke and Pepsi (price is Rs. 25), as of 2021; GST
@28% plus 12%
 The Impact of a Tax on Carbonated Beverages
Price
Without the tax, market equilibrium occurs at point (rupees S2
per can)
A.
S1
The equilibrium price of SSBs is 18.00 per can, and B
24
6 billion cans of soft drinks are sold per year.

A 7 rupees-per-can tax on SSBs will cause the 18 A

supply curve for drinks to shift up by Rs.7, from S1
to S2.

The new equilibrium occurs at point B. 0 5 6 Quantity of cans

The price of cans will increase by 7, to Rs 24 per pack, and the quantity sold (billions of cans per year)
will fall to 5 billion cans.
 What Happened to the Supply Curve?
Price
The supply curve shifted up by 7, the amount of the (rupees S2
per can)
tax.
S1
If firms were willing to sell 6 billion cans at a price B
24
of Rs. 18 before the tax, the price needs to be
exactly Rs. 7 higher in order to convince them to
18 A
still sell 6 billion cans.

This is because firms’ marginal costs effectively

increased by Rs. 7 per unit.

0 5 6 Quantity of cans
(billions of cans per year)
 The Impact of a Tax on Coke/Pepsi Cans
Price
The tax increases the price paid by consumers to 24 (rupees S2
per can)
per can.
Tax
revenue S1
Producers receive a price of 24 per can (point B
24
B), but after paying the 7 tax, they are left with 17
(point C).
18 A Deadweight loss
17 or excess burden
The government will receive tax revenue equal to C from tax

the blue-shaded box.

Some consumer surplus and some producer surplus will

0 5 6 Quantity of cans
become tax revenue for the government, and some will (billions of cans per year)
become deadweight loss, shown by the yellow-shaded
area.
Tax Incidence on a Demand and Supply Graph
Price
With no tax on beverages, the price would be 18 per can, (rupees S2
per can)
and 6 billion cans of Coke/Pepsi would be sold each year.
Tax
revenue S1
• A 7-rupees-per-can excise tax shifts up the supply B
curve from S1 to S2. 24

• The price consumers pay rises from 18 to 24.

18 A Rs.7 GST shifts
17 the supply curve
• The price sellers receive falls from 18 to 17. up
C

Therefore, consumers pay 6 rupees of the 7-rupees-per-can

tax on soft drinks, and sellers pay 1 rupee.
0 5 6 Quantity of cans
(billions of cans per year)
Who Actually bears the burden of a Tax? (Tax Incidence)

In the market for carbonated beverages, the buyers effectively paid 86% of the 7-rupees-per-
can GST, and sellers paid 14%.

This is known as the tax incidence: the actual distribution of the burden of a tax between
buyers and sellers in a market.

What determines this tax incidence? You would see that the answer is not “whoever is legally
obligated to pay the tax…”
What Does Determine the Tax Incidence?

The incidence of the tax is determined by the relative slopes of the demand and supply
curves.

A steep demand curve indicates that buyers hardly change how much they buy when price
changes; this results in them taking on much of the burden of the tax.

If the demand curve were flatter, buyers would change how much they purchased
considerably in response to a change in price. Then they could not be compelled to accept as
much of the burden of the tax.

• Same logic applies for sellers.

Deadweight Losses and Gains from Trade

 Why do taxes cause deadweight losses?

 Suppose, Ram cooks at Sarita’s house for Rs. 8,000/month. The opportunity cost of Ram’s
time is Rs. 6,000, and the value of homemade food to Sarita is Rs. 10,000.

 Gains from trade is Rs. 4,000

 Government imposes a tax of Rs. 4500 on the agency which supplies cooks

 The tax has made both Sarita and Ram worse off by Rs. ?
What determines the Deadweight Loss?
Price
(rupees S2
per can)

S1
B
24

18 A

0 5 6 Quantity of cans
(billions of cans per year)
Things to remember to avoid common mistakes

Scarcity and shortage are not the same; both have technical meanings. There is no shortage of most
scarce goods.

Price ceilings are only effective if they are placed below the equilibrium price. Similarly, price floors are
effective only when above the equilibrium price.

When showing a tax, if sellers are legally obligated to pay the tax, move the supply curve up by the
amount of the tax; if buyers are obligated to pay the tax, move the demand curve down by the amount
of the tax.

The legal obligation to pay a tax is not the same as the tax burden.
To sum up

 Tools of Welfare economics used for assessing efficiency of free markets

 Forces of SS and DD allocate resources efficiently (Adam Smith’s invisible hand)

 Market does not always allocate resources efficiently

 Two key assumptions about market

Demand and Supply Equations
Suppose that the demand for a medicine in Mumbai is

QD = 4,750,000 − 1,000P

and the supply of the medicine is QS = −1,000,000 + 1,300P

In equilibrium, we know QD = QS (This is known as the equilibrium condition.)

We use this to find the equilibrium price and quantity:

4,750,000 − 1,000P = −450,000 + 1,300P

5,750,000 = 2,300P

P = 5,750,000 / 2,300

= 2,500
Equilibrium
Find the equilibrium quantity of medicines sold:

QD = 4,750,000 – 1,000P

= 4,750,000 – 1,000(2,500)

= 2,250,000 or

QS = – 1,000,000 + 1,300P

= – 1,000,000 + 1,300(2,500)

= 2,250,000

We have found the equilibrium price and quantity; we can insert this on a demand and supply graph.
Contd..
To complete the diagram, let’s find the y-intercepts of the demand and supply curves, by setting QD
and QS equal to zero:

QD = 4,750,000 – 1,000P

0 = 4,750,000 – 1,000P

P = 4,750,000 / 1000

= 4,750

QS = –1,000,000 + 1,300P

0 = –1,000,000 + 1,300P

P = –1,000,000 / –1,300

= 769.23
The Efficiency of Competitive Equilibrium
Price Supply
Now we can calculate estimated
consumer and producer surplus, 4,750 Consumer
Surplus
using the triangle area formula:

Area = ½ (base)(height)
2500
CS = ½(2,250,000)(4,750 – 2,500)

= Rs. 2531.25 million

PS = ½(2,250,000)(2,500 – 769) Producer

Surplus
769
= Rs. 1947.375 million
Demand
0 Quantity
 Price Ceiling:
Suppose the govt imposes a price ceiling of 1,500 per strip.
Calculate the quantity of medicines that will be sold:
Price SS

QS = – 1,000,000 + 1,300P

= – 1,000,000 + 1,300(1,500)
3800
= 950,000
2500
Price Control
Find the price on the demand curve when the quantity of
medicines is 950,000: 1500

QD = 4,750,000 – 1,000P

950,000 = 4,750,000 – 1,000P

P = –3,800,000 / –1,000 DD
0 950,000 2,250,000 Quantity
= 3,800
 Price Ceiling:
Suppose the govt imposes a price ceiling of 1,500 per strip.
Calculate the quantity of medicines that will be sold:
Price SS

QS = – 1,000,000 + 1,300P

= – 1,000,000 + 1,300(1,500)
3800
= 950,000 B
2500
Price Control
Find the price on the demand curve when the quantity of C
A
medicines is 950,000: 1500

QD = 4,750,000 – 1,000P
D
950,000 = 4,750,000 – 1,000P

P = –3,800,000 / –1,000 DD
0 950,000 2,250,000 Quantity
= 3,800
 Price Ceiling:
Now the diagram can guide our numerical estimates of
the economic effects of the rent controls.
Price SS

Triangles B + C represent the deadweight loss. Area B is:

½ × (2,250,000 – 950,000) × (3,800 – 2,500) 3800

B
= Rs. 845 million 2500
Price Control
C
Area C is:
1500

½ × (2,250,000 – 950,000) × (2,500 – 1,500)

= Rs. 650 million

So the deadweight loss is DD

845 + 650 = Rs. 1,495 million. 0 950,000 2,250,000 Quantity
Computing the Change in Surplus for Consumers
Consumers lose area B (845 million) but gain the area of rectangle A:

(2,500 – 1,500) × (950,000)

= Rs. 950 million

So consumer surplus changes from Rs. 2531.25 million to:

(2531.25 + 950) – 845

= Rs. 2636.25 million (Gain or loss?)

Computing the Change in Surplus for Producers

Producers lose area A (950 million) and area C (650 million); they originally had a
surplus of Rs. 1947.375 million, so now producer surplus is:

1947.375 – (950 + 650)

= 347.375 million