Question

Answer the following questions from you knowledge in microeconomic theory:

A.      Show, using only the industry demand and long-run supply curves (for an increasing cost industry), the effects on price and output of an excise subsidy paid to the firms. Who benefits from the subsidy?

B.      Can you think of any type of subsidy that, if given to firms in a competitive market, would in the long run benefit (the owners of) the firms? Why wouldn’t entry of new firms into the subsidized market always occur until economic profits are zero?

Answer 1

Taxes are not the most popular policy, but they are often necessary. We will look at two methods to understand how taxes affect the market: by shifting the curve and using the wedge method. First, we must examine the difference between legal tax incidence and economic tax incidence.

• Legal versus Economic Tax Incidence

When the government sets a tax, it must decide whether to levy the tax on the producers or the consumers. This is called legal tax incidence. The most well-known taxes are ones levied on the consumer, such as Government Sales Tax (GST) and Provincial Sales Tax (PST). The government also sets taxes on producers, such as the gas tax, which cuts into their profits. The legal incidence of the tax is actually irrelevant when determining who is impacted by the tax. When the government levies a gas tax, the producers will pass some of these costs on as an increased price. Likewise, a tax on consumers will ultimately decrease quantity demanded and reduce producer surplus. This is because the economic tax incidence, or who actually pays in the new equilibrium for the incidence of the tax, is based on how the market responds to the price change – not on legal incidence.

• Tax – Shifting the Curve,

we determined that the supply curve was derived from a firm’s Marginal Cost and that shifts in the supply curve were caused by any changes in the market that caused an increase in MC at every quantity level. This is no different for a tax. From the producer’s perspective, any tax levied on them is just an increase in the marginal costs per unit. To illustrate the effect of a tax, let’s look at the oil market again.

If the government levies a $3 gas tax on producers (a legal tax incidence on producers), the supply curve will shift up by $3. As shown in Figure 4.8a below, a new equilibrium is created at P=$5 and Q=2 million barrels. Note that producers do not receive $5, they now only receive $2, as $3 has to be sent to the government. From the consumer’s perspective, this $1 increase in price is no different than a price increase for any other reason, and responds by decreasing the quantity demanded for the higher priced good.

What if the legal incidence of the tax is levied on the consumers? Since the demand curve represents the consumers’ willingness to pay, the demand curve will shift down as a result of the tax. If consumers are only willing to pay $4/gallon for 4 million gallons of oil but know they will face a $3/gallon tax at the till, they will only purchase 4 million gallons if the ticket price is $1. This creates a new equilibrium where consumers pay a $2 ticket price, knowing they will have to pay a $3 tax for a total of $5. The producers will receive the $2 paid before taxes.

Market Surplus

Like with price and quantity controls, one must compare the market surplus before and after a price change to fully understand the effects of a tax policy on surplus.

Figure 4.7d

Before

The market surplus before the tax has not been shown, as the process should be routine. Ensure you understand how to get the following values:

Consumer Surplus = $4 million

Producer Surplus = $8 million

Market Surplus = $12 million

After

The market surplus after the policy can be calculated in reference to Figure 4.7d

Consumer Surplus (Blue Area) = $1 million

Producer Surplus (Red Area)= $2 million

Government Revenue (Green Area) = $6 million

Market Surplus = $9 million

• Why is Government Included in Market Surplus

In our previous examples dealing with market surplus, we did not include any discussion of government revenue, since the government was not engaging in our market. Remember that market surplus is our metric for efficiency. If government was not included in this metric, it would not be very useful. In this case a million-dollar loss to government would be considered efficient if it resulted in a $1 gain to a consumer. To ensure that our metric for efficiency is still useful we must consider government when calculating market surplus.

B.

In perfectly (and imperfectly) competitive markets, is it appropriate to assume profit maximization on the part of firms? At the outset we should recognize that any profit real- ized by a business belongs to the business owner(s). For the millions of small businesses with only one owner-manager, decisions concerning what products to carry, whom to employ, what price to charge, and so on, will be heavily influenced by the way the owner’s profit is affected. Owners of such businesses may well have goals such as early re- tirement or expensive educations for their children. These goals, however, are not incon- sistent with the assumption of profit maximization. Since money is a means to many ends, early retirement or college educations can more easily be afforded when the owner makes more money.

A possible problem with assuming profit maximization is that the owner-manager cannot have detailed knowledge of the cost and revenue associated with each action that could be

taken to maximize profit. Economic theory, however, does not require that firms actually know or think in terms of marginal cost and revenue, only that they behave as if they did.

As with the quota – both consumer and producer surplus decreased because of a reduced quantity. The difference is, since the price is changing, there is redistribution. This time, the redistribution is from consumers and producers to the government. Remember, only a change in quantity causes a deadweight loss. Price changes simply shift surplus around between consumers, producers, and the government.

Firms may come close enough to maximizing profit by trial and error, emulation of success ful firms, following rules of thumb, or blind luck for the assumption to be a fruitful one.

When we move from the small, owner-managed firm to the large, modern corpora tion, another potential criticism of the profit maximization assumption arises. A charac- teristic of most large corporations is that the stockholder-owners themselves do not

make the day-to-day decisions about price, employment, advertising, and so on. Instead,

salaried personnel of the corporation—managers—make these decisions. And so there is

a separation of ownership and control in the corporation; managers control the firm, but

stockholders own it. It is safe to assume that stockholders wish to make as much money

on their investment as possible, but it is virtually impossible for them to constantly

monitor their managers’ actions. Therefore, managers will have some discretion, and

some of their decisions may conflict with the stockholder-owners’ profit-maximizing

goals.

While managers may have some discretion to deviate from the profit-maximizing goals

of firms’ shareholder-owners, several factors limit the exercise of such discretion. For ex-

ample, stockholder-owners often link business managers’ compensation to profits, some-

times paying them in part with shares of stock or stock options, in order to give an incentive to pursue profits more actively. In addition, the profitability managers achieve in a given enterprise will affect their job prospects with others. And, finally, if managers do not make as large a profit as possible, stock prices, which tend to reflect profitability (especially projected profitability), will be lower than need be. Undervalued stock creates an incentive for outsiders, or “raiders,” to buy up a controlling interest in the firm and re- place the inefficient management team. A firm that neglects profit opportunities too often leaves itself open to such a takeover bid, a fairly common occurrence in the corpo-

rate world.

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