Tutorial questions 5.

a. Tax incidence refers to the distribution of the burden of a tax between producers and
consumers. In a perfectly competitive market, the price is determined by the intersection of the
supply and demand curves. The tax burden, regardless of whether it is imposed on producers or
consumers, is ultimately shared between them.

If a tax is imposed on producers, it increases their production costs. As a result, the supply curve
shifts upward, leading to a higher equilibrium price and a lower quantity traded. The producers
will bear a portion of the tax burden by receiving a lower price for their goods.

On the other hand, if a tax is imposed on consumers, it directly increases the price they have to
pay. This leads to a decrease in demand, causing the demand curve to shift downward. The
consumers will bear a portion of the tax burden by paying a higher price for the goods they
purchase.

In a perfectly competitive market, the tax burden is shared between producers and consumers,
regardless of who the tax is initially imposed on. The final distribution of the tax burden depends
on the relative elasticities of supply and demand. If either the supply or demand is more elastic,
that party will bear a smaller portion of the tax burden.

b. Pure public goods are non-excludable and non-rivalrous. Non-excludability means that it is
impossible to exclude individuals from consuming the good once it is provided. Non-rivalry
means that one person's consumption of the good does not diminish the quantity available for
others. Examples of pure public goods include national defense, street lighting, and public parks.

Impure public goods, also known as quasi-public goods, have characteristics of both public
goods and private goods. They may have some degree of rivalry or excludability. For example, a
toll road is excludable because only those who pay the toll can use it, but it is still non-rivalrous
since one person's use of the road does not reduce its availability to others. Another example is
cable television, where it is possible to exclude non-subscribers and the consumption of one
subscriber does not diminish the availability to others.
c. Marginal tax rate refers to the tax rate applied to an additional unit of income. It is calculated
as the change in tax divided by the change in income resulting from that additional unit.
Marginal tax rates often increase with income in progressive tax systems.

Average tax rate, on the other hand, is the total tax paid divided by total income. It represents the
average percentage of income that is paid in taxes.

To summarize, the marginal tax rate focuses on the tax burden of each additional unit of income,
while the average tax rate provides an overall measure of the tax burden as a percentage of total
income.

d. The statement that cigarette sales do not change much when cigarette taxes are increased does
not necessarily allow us to conclude that cigarette companies bear most of the burden of the tax.
The lack of a significant change in sales could be due to several factors, such as the addictive
nature of cigarettes or the inelastic demand for them.

QUESTION 2.
a. Government Failure refers to situations where the government's intervention or actions lead to
an inefficient allocation of resources or the failure to achieve desired outcomes. It occurs when
government policies or actions result in unintended consequences, inefficiency, or negative
impacts on the economy or society. Examples of government failure include bureaucratic
inefficiencies, corruption, unintended consequences of regulations, and misallocation of
resources due to political considerations.

Market Failure, on the other hand, occurs when the free market fails to allocate resources
efficiently or fails to provide desired outcomes. It happens when there is a failure in the price
mechanism, resulting in an inefficient allocation of resources. Market failures can include
externalities (positive or negative effects on third parties not involved in the transaction), public
goods (goods that are non-excludable and non-rivalrous), information asymmetry (when one
party has more information than the other), and market power (when a single buyer or seller has
significant control over prices).

b. The statement that "Publicly provided private goods are characterized by features similar to
impure public goods" refers to situations where the government provides goods or services that
are typically considered private goods, but they exhibit characteristics similar to impure public
goods.

Private goods are characterized by being excludable (people can be prevented from using them)
and rivalrous (one person's use diminishes the availability for others). However, when the
government provides these goods, they may face difficulties in effectively excluding individuals
from using them or they may not be fully rivalrous.

For example, consider a government-provided healthcare system. Healthcare services are

typically considered private goods because they can be excluded and are rivalrous (one person's
use of a doctor's time reduces the availability of that time for others). However, when the
government provides healthcare, it becomes difficult to exclude individuals from using the
services, especially if it is funded through taxes. Additionally, the provision of healthcare
services to one person may also benefit others indirectly through reduced disease transmission or
improved public health.

c. Market mechanisms are unlikely to provide public goods efficiently, even if such goods are
excludable in consumption, due to the free-rider problem. Public goods are goods that are non-
excludable (people cannot be easily prevented from using them) and non-rivalrous (one person's
use does not diminish availability for others). Examples of public goods include national
defense, street lighting, and public parks.

In a market setting, individuals have an incentive to free-ride, which means they can benefit from
the provision of public goods without contributing to their production. Since individuals cannot
be excluded from using public goods, and there is no direct market mechanism to capture the
benefits received, private firms have little incentive to produce public goods. As a result, public
goods are typically underprovided in a purely market-based system.

For example, consider the construction of a public park. If a private company invests in building
a park, it cannot prevent people from using it without charging a fee. However, if the company
charges a fee, some individuals may choose not to pay and still enjoy the benefits of the park.
This creates a free-rider problem, and the private company may not find it profitable to build and
maintain the park.
d. Positive and negative externalities can occur in both consumption and production.

Positive externalities occur when an economic activity generates benefits for third parties who
are not directly involved in the transaction. For example, when a person plants trees in their
backyard, it improves the air quality and aesthetic value of the neighborhood, benefiting the
entire community. The positive effects spill over beyond the individual's private benefit.

Negative externalities occur when an economic activity imposes costs on third parties who are
not directly involved in the transaction. For instance, when a factory emits pollution into the air
or water, it harms the surrounding environment and the health of nearby residents. The costs
associated with pollution are borne by others, creating a negative externality.

In production, positive externalities can arise when firms generate spillover benefits. For
example, a company investing in research and development (R&D) may create new knowledge
that benefits other firms in the industry. The positive effects of the R&D spill over to other firms,
leading to increased innovation and productivity.

In consumption, positive externalities can occur when an individual's consumption choices

benefit others. For instance, if someone gets vaccinated against a contagious disease, they not
only protect themselves but also reduce the risk of spreading the disease to others.

On the other hand, negative externalities in consumption can happen when an individual's
consumption choices impose costs on others. For example, smoking tobacco not only harms the
smoker's health but also exposes others to secondhand smoke, creating a negative externality.

e. There are several solutions to the problem of externalities:

1. Government Regulation: Governments can impose regulations and standards to internalize

external costs or benefits. For example, environmental regulations can limit pollution emissions
from factories, reducing negative externalities. Similarly, the government can mandate
vaccinations to address the negative externalities associated with contagious diseases.
2. Pigouvian Taxes and Subsidies:Governments can impose taxes or provide subsidies to correct
externalities. A Pigouvian tax is a tax levied on a good or activity that generates negative
externalities. By increasing the cost of the activity, the tax incentivizes producers or consumers
to reduce their negative externalities. Conversely, the government can provide subsidies to goods
or activities that generate positive externalities to encourage their production or consumption.

For example, a carbon tax can be imposed on industries that emit greenhouse gases, which helps
internalize the negative externality of climate change. Alternatively, the government can provide
subsidies for renewable energy generation to promote its positive externality of reducing carbon
emissions.

3. Tradable Permits: Tradable permits, also known as cap-and-trade systems, allow the
government to limit the total level of pollution while allowing firms to trade permits representing
the right to emit a certain amount of pollution. This creates a market mechanism for allocating
pollution rights efficiently. Firms with lower costs of reducing pollution can sell their permits to
firms with higher costs, resulting in an overall reduction in pollution at a lower cost.

4. Coase Theorem and Negotiation: The Coase Theorem suggests that if property rights are well-
defined and transaction costs are low, private parties can negotiate and reach efficient outcomes
without government intervention. In this approach, affected parties can negotiate and come to
mutually beneficial agreements to internalize externalities.

For example, suppose a factory emits pollution that harms a nearby residential area. The
residents can negotiate with the factory and reach an agreement to reduce pollution levels or
provide compensation for the damages caused.

f. To illustrate the statement that market equilibrium with externalities requires setting the
Marginal Social Cost (MSC) equal to the Marginal Social Benefit (MSB), we can use a diagram:

```
^
| MSC
| /
 | /
| /
|/
|/
------------------------->
Quantity of Output
```

In a competitive market without externalities, the equilibrium occurs where the marginal private
cost (MPC) intersects with the marginal private benefit (MPB). However, when there are
negative externalities, the MPC does not reflect the full cost to society, as it does not include the
external costs imposed on third parties.

The Marginal Social Cost (MSC) accounts for both the private costs and the external costs
associated with the negative externality. It is located above the MPC curve to represent the
additional costs imposed on society.

The Marginal Social Benefit (MSB) represents the additional benefit to society from consuming
an additional unit of the good. It is usually equivalent to the marginal private benefit (MPB), as
externalities typically do not affect the benefits received by consumers.

Efficiency requires setting the MSC equal to the MSB. This occurs at the socially optimal
quantity of output, where the MSC intersects with the MSB curve. At this point, the level of
production maximizes societal welfare by considering all costs and benefits, including the
external costs.

g. Tax Avoidance and Tax Evasion are two different concepts related to the payment of taxes:

Tax Avoidance refers to the legal practice of arranging one's financial affairs in such a way as to
minimize the amount of tax owed. It involves taking advantage of tax incentives, exemptions,
loopholes, and deductions provided by the tax laws. Tax avoidance is considered a legitimate and
legal way to reduce tax liabilities, as long as it complies with the tax regulations in place.

For example, an individual who invests in tax-advantaged retirement accounts to lower their
taxable income is engaging in tax avoidance. Similarly, a corporation structuring its operations to
take advantage of lower tax rates in a particular jurisdiction is also engaging in tax avoidance.

Tax Evasion, on the other hand, refers to the illegal and deliberate act of evading taxes by
intentionally misrepresenting or concealing income, assets, transactions, or other information
from tax authorities. It involves illegal activities such as underreporting income, inflating
deductions, keeping unrecorded transactions, or using fraudulent documents to evade tax
obligations.

For instance, an individual who fails to report cash income or a business that maintains two sets
of accounting books to hide taxable income is engaging in tax evasion. Tax evasion is considered
illegal and can lead to severe penalties, including fines, imprisonment, or both.

The key distinction between tax avoidance and tax evasion is that tax avoidance seeks to
minimize tax liabilities within the boundaries of the law, while tax evasion involves intentionally
evading taxes through illegal means.