Question

The following question is about markets and government policies.

a. Explain the difference between a binding and non-binding price ceiling. What is the intuition behind this?

b. If the government is trying to increase tax revenue, what should they know about the Laffer Curve?

c. Draw and fully explain the welfare impacts of a per unit tax on the seller.

d. If the government wants to slow consumer spending, why might they consider using taxation? Explain your answer.

Answer 1

a. A binding price ceiling is a maximum limit imposed on the market price in case the ceiling price is below the market price. Due to this reason it is binding on the consumer and producer to make a transaction at this price only. A non binding price ceiling is a ceiling price that is imposed above the market price and is therefore not binding on the market. This is because the current price is already below the maximum price. The intuition behind setting a binding price ceiling is to make a particular good affordable for consumers and to restrict producers using price gouging.

b. The government must be aware of the current location on the Laffer Curve. If the government finds itself on the falling portion of the curve then, any further increase in the tax would reduce revenue so it would not be an optimal decision to increase tax. On the other side if the government finds itself on the rising portion of the curve then any further increase in the tax rate increases the revenue so it would be a wise decision to raise taxes.

c. When there is a specific tax imposed on a good sold by the seller it increases its market price. However for the seller the after-tax prices reduced and this also reduces the quantity sold by it when the supply curve shifts to the left. There is a reduction in the producer surplus and hence the welfare of the seller is reduced. This happens because the quantity as well as the price received for each unit, both are reduced as a result of tax.

d.The government should increase the taxation because when taxes are increased the disposable income of consumer is reduced and with lower income consumers are likely to reduce consumption on most of the goods and services.