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ECON649/ECON991

ECON649/ECON991. Lecture 4. Applications of Supply & Demand Analysis: Per-Unit Taxes. Per-unit Tax (also called a Specific Tax) . Now consider govt intervention via imposition of a per-unit tax We will suppose that the tax is levied on the producer

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ECON649/ECON991

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  1. ECON649/ECON991 Lecture 4

  2. Applications of Supply & Demand Analysis: Per-Unit Taxes

  3. Per-unit Tax (also called a Specific Tax) • Now consider govt intervention via imposition of a per-unit tax • We will suppose that the tax is levied on the producer (i.e. a specific amount of tax is applied to each unit produced) • We are interested in: • Impact on equilibrium P and Q and • Who bears the burden of the tax (Just consumers? Just producers? Both of them?)

  4. Per-unit tax Stax P S • A per-unit tax can be represented as a vertical shift (by the amount of the tax) of the supply curve. • This is because the tax can be thought of as an increase in the costs of production, so that at every quantity the price charged must be higher to cover the additional cost of the tax. P0 + t Per unit tax = t P0 Q0 Q

  5. Per-unit tax Tax per unit Snew P • Suppose we have the market D and S curves for the product to be taxed and that the market is in equilibrium  P*, Q*. • Now suppose govt imposes per-unit tax on production of this good Sorig E1 P*new E* H P* P2 G D 0 Q*new Q* Q

  6. Per-unit tax Tax per unit Snew P • With each extra unit of output produced, the producer needs to hand over specific number of dollars to the tax department. • As already stated this is an increase in production costs. • From our coverage of the supply side of the market, we know that an increase in production costs  decrease in supply (i.e. S curve shifts left) Sorig E1 P*new E* H P* P2 G D 0 Q*new Q* Q

  7. Per-unit tax Tax per unit Snew P • In the diagram, Sorig shifts to the left with the vertical distance between Sorig and Snew exactly equal to the per-unit tax (=distance E1G, or P*new– P2) • The shift to Snew creates a shortage (=distance E*J) at P*  P until new equilibrium is reached at P*new, Q*new Sorig E1 P*new E* J H P* P2 G D 0 Q*new Q* Q3 Q

  8. Per-unit tax Tax per unit Snew P • Whilst producers hand over the set per-unit amount of tax to the government, not all of the tax is passed on to consumers in the form of a higher price. The tax per-unit = distance E1G BUT P = just E1H (E1H < E1G) Sorig E1 P*new E* J H P* P2 G D 0 Q3 Q*new Q* Q

  9. Per-unit tax Tax per unit Snew P • The tax per-unit is therefore shared by consumers and producers • On a per-unit basis Consumers’ burden = P = P*new – P* = E1H • Total consumers’ burden = P*P*newE1H Sorig E1 P*new E* J H P* P2 G D 0 Q*new Q* Q3 Q

  10. Per-unit tax Tax per unit Snew P On a per-unit basis • Consumers’ burden = P = P*new – P* =E1H • Producers’ burden = P* - P2 = GH • Per-unit Tax = E1H + GH = E1G • Total consumers’ burden = P*P*newE1H • Total producers’ burden = P2P*HG Sorig E1 P*new E* J H P* P2 G D 0 Q*new Q* Q3 Q

  11. Per-unit tax Tax per unit Snew P • With ordinary D and S curves, part of tax shifted on to consumers and the rest is born by producers Sorig E1 P*new E* J H P* P2 Consumers’ burden G D Producers’ burden 0 Q*new Q* Q3 Q

  12. Consumers’ burden Per-unit tax Tax per unit P Snew • Changes in the slopes of the Demand and Supply curves affect the proportions of the tax paid by consumers and producers. • Consider a steep supply curve • Burden of the tax falls substantially on the producer. Sorig E1 P*new E* P* P2 G D 0 Q*new Q* Q

  13. Per-unit tax Tax per unit P Snew • Consider a steep demand curve • Burden of the tax falls more on the consumer. Sorig P*new E1 P* E* Consumers’ burden P2 G Producers’ burden D 0 Q*new Q* Q

  14. Per-unit tax (Summary of findings) • The amount of tax that a consumer or producer pays depends on the slope of their respective demand and supply curves. • The steeperthe demand curve, or the flatterthe supply curve, the more of the tax is paid by the consumer. • The flatterthe demand curve, or the steeperthe supply curve, the more of the tax is paid by the producer.

  15. HOMEWORKPer-unit tax – numerical example S = P + 2 • A numerical example is provided on the Unit Website for students to review at home. S = P + 5 P E2 Size of tax = $3 per unit 6 E1 5 3 D 8 10 Q

  16. Production and Costs

  17. Production and Costs • Our objective is to come to grips with a number of important concepts that are central to the production or supply side of the market. • An understanding of these concepts is essential background knowledge for explaining behaviour of firms in different market structures.

  18. Introduction • It is usual to assume that each firm makes decisions as if it is a single individual. • Also usual to assume goal of every firm is to maximise profits (π max). • With π max assumed and with π = difference between firm’s revenue and its costs, need to understand how • Costs vary with firm’s output & • Revenue varies with output & market structure

  19. Introduction • Eventually bring costs and revenue together to explain π maximisation/loss minimisation behaviour of different firms. • In accounting: π = revenue – explicit costs • In economics: π = revenue (TR) – totalcosts (TC) • In this course π = economic profit • Total costs = explicit costs + implicit costs

  20. Introduction • Need to distinguish between EXPLICIT and IMPLICIT COSTS Value of inputs already owned by firm and used in production. e.g. value of owner’s risk-taking activities. Therefore, implicit costs include a ‘normal’ return for the owners’ entrepreneurship. Value of inputs purchased by firm and used in production.

  21. Production in the Short-Run • Production is the transformation of inputs into output. • An input/factor is anything that the firm purchases and utilises in the production process (i.e. resources). • Output is what the firm sells.

  22. Production in the Short-Run There are 2 types of inputs: • Variable inputs/factors = inputs that can be  or  in short-run so as to  or  output ( variable inputs vary with output level) • Fixed inputs/factors = inputs that cannot be  in short-run ( level of input is invariant with respect to output in short-run) • Total Product function (TP) shows relationship between various inputs and maximum quantity of output, given the level of technology.

  23. Production in the Short-Run • Whether an input is fixed or variable depends on the time period considered. • Short-run(SR) = period too brief to permit firms to alter all of its inputs  SR has at least 1 fixed input • Long-run (LR) = period long enough to allow firm to vary all inputs  LR has no fixed inputs

  24. Marginal Product The relationship between changes in total output (a.k.a. total product) and changes in a variable input (or factor), e.g. labour, is called Marginal Product (MP). MP = TP V MP = the change in TP when we add one more unit of a variable factor, with all other inputs held constant.

  25. Law of Diminishing Marginal Returns • The Law of Diminishing Marginal Returns (L of DMR) states “As more variable factor is added to a firm’s fixed factor, marginal product will eventually decline.” • L of DMR explains the shape of the MP curve. • The shape of MP is very important because it influences the shape of several cost curves (later).

  26. Law of Diminishing Marginal Returns • Consider the data in the table on the next slide • Without variable factor, nothing is produced •  amount of variable factor output (TP) • Marginal product = change in TP from  variable factor (V) by 1 unit MP = TP/V = slope of TP • Data reflects law of diminishing marginal returns

  27. Production in the Short-Run

  28. Important Points Regarding the L of DMR • L of DMR is a short-run concept, because occurs when firm has at least 1 fixed input • MP occurs as a result of changes to input mix (eventually fixed input is swamped with more and more variable input, note that the quality of the inputs remains unchanged (i.e. each extra unit of input is of the same quality as the one before)) • L of DMR relates to MP not TP

  29. Relationship between Marginal and Average

  30. Summary of Relationship between Marginal and Average • marginal > average  average  • marginal < average  average  • marginal = average  average is either at a maximum or a minimum • If average is constant then marginal = average

  31. $ TFC 0 Q Production Costs in the SR • In the SR we have both fixed and variablecosts. • Total Fixed Cost (TFC) = expenditure on a fixed factor of production. i.e. these costs do not vary as output changes, and must be paid even if output is zero. So TFC is independent of the output level.

  32. $ TVC 0 Q Production Costs in the SR • Total Variable Cost (TVC) = expenditure on a variable factor of production. i.e. these costs vary as output changes • Variable input  as output  TVC will always rise as Q  • So TVC is dependent on the output level. If output = 0, TVC = 0.

  33. $ TC TVC TFC 0 Q Production Costs in the SR • Total Cost (TC) = TFC + TVC • Total cost is parallel to TVC, vertical distance between TC and TVC = TFC

  34. Production Costs in the SR • Averages

  35. Production Costs in the SR AFC ATC AVC ATC AVC AFC Q Q Q

  36. Marginal Cost = extra or additional cost associated with the production of 1 extra unit of output. However, since TFC/Q = 0, thenMC = TVC/Q Production Costs in the SR

  37. Let PV = $1 MPMC (=(1/MP) x $1) 1/2 1/3 1/4 1/3 1/2 Key inverse relationships Price of variable factor • MP & MC MP 4 V MC ¼ Q

  38. Key inverse relationships AP • AP & AVC V AVC Q Note: The MC curve passes through the minimum points of both the AVC and the ATC curves.

  39. Long Run Average Cost (LRAC) • Remember in the LR all factors are variable. • One way of deriving LRAC is to view the long run as a planning horizon. • Firm has its existing plant size and imagines what it would be like to produce with different scales of plant. • Firm determines cost curves for all different scales of plant  series of short-run ATCs, one for each different size plant. • Firm plots all SR ATCs on the same graph.

  40. SRATCL SRATCS cost SRATCM F B D A C E Q Long Run Average Cost (LRAC) • Suppose a firm is considering what size plant to build in the future – it has 3 possibilities – a small, medium or large factory. LRAC Q3 Q1 Q2

  41. Long Run Average Cost (LRAC) • In the LR there are an infinite number of possible plant sizes to choose from. So in the LR we end up with a smooth LRAC curve. SRAC curves LRAC Cost per unit Q

  42. Long Run Average Cost (LRAC) • So taking a smooth envelope of all the SRAC curves we obtain a firm’s LRAC curve. SRAC curves LRAC Cost per unit Q

  43. Long Run Average Cost (LRAC) • LRAC curve shows the lowest average cost of producing any given level of output. SRAC curves LRAC Cost per unit Q

  44. costs LRAC at min Constant returns to scale % inputs = % output LRAC LRAC declining Economies of scale(Increasing Returns to Scale) % inputs < % output LRAC increasing Diseconomies of scale(Decreasing Returns to Scale) % inputs > % output Q Long Run Average Cost (LRAC) • The U-shape of the LRAC curve is due to returns to scale.

  45. REQUIRED READING This week’s lecture: Per-Unit Taxes • Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics Chapter 5(pp.143-146) Production and Costs • Hubbard, Garnett, Lewis & O’Brien, Essentials of EconomicsChapter 6

  46. REQUIRED READING Next week’s lecture: Perfect Competition • Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics Chapter 7

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