8. Application: the Costs of Taxation
8.2. The Determinants of Deadweight Loss
Deadweight loss of taxation increases with the elasticity of supply and demand.
Deadweight loss of taxation is mainly determined by the elasticity of supply and demand. If the elasticity of supply is small, meaning that supply cannot well adjust to price changes the deadweight loss is small as well. When supply is more elastic this means that it will respond in larger quantities to the increase in price due to the tax, therefore the deadweight loss will be large. The same logic applies to the elasticity of demand. Low elasticity means that demand will not respond much and there will not be much deadweight loss.
Example:
The concept of deadweight loss has a lot of influence on current political debate, such
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as the appropriate size of the government. If taxes do not cause large deadweight losses then perhaps the government should be quite big, since it can be beneficial, but if the losses are large then that is a good argument for smaller governments. The largest tax in the US is the labour tax, which, taking into account all of the types of labour taxes, amounts to about 40%. Some economists say that labour supply is inelastic and that this tax does not have a large deadweight loss. Others say that labour supply is elastic and this tax causes people to work less hours, some not to work at all, elderly retire early and some to enter into illegal activities. Which is true is subject to debate and requires a lot of investigation.
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9. Application: International Trade
In order to determine the effects of international trade on a countries economy, we should compare the world price and the domestic price with no trade. If the world price is greater than the domestic price it is likely that the country will be an exporter, which will be beneficial for its producers, but damaging to the consumers, since their prices will rise. If the world price is smaller than the domestic one, the country is likely to become an importer, which will reduce the prices for consumers and benefit them, yet will be damaging to local producers. However, in each case free trade will have a net benefit on society. Countries may choose to impose tariffs, which are taxes on imported goods, however this removes some of the benefits of free trade. There are reasonable arguments to restrict trade sometimes, like in order to protect infant industries, retaliate to other countries trade restrictions or protect national security.
However, they are all debatable.
9.1. The Determinants of Trade
The difference between domestic and world price determines, whether a country is an exporter or an importer.
Under autarky, which is a situation when a country does not engage in trade at all, a small country’s economy would work according to the basic principles of supply and demand, price would equilibrate the quantity of a product in the market and consumers and producers would share a particular amount of surplus. When the country opens up to international trade, since it is a small country it cannot influence the world price for whatever good it is producing. Depending on whether the domestic price is smaller or larger than the world price we can say if the country has or has not a comparative advantage for that good. If the domestic price is lower than the world price, the country has a comparative advantage and shall start to export the good, but if the price is higher it will become an importer. Even though we may think that this would harm the
producers of the good, which will now be pushed out of business by imports, trade will still be beneficial to the economy as a whole, because now the country will be able to specialize in what it does relatively best and buy the good it used to make for a smaller price from importers.
9.2. The Winners and Losers from Trade
Domestic producers are harmed by imports and domestic consumers are harmed by price increases due to exports, but society and economy as a whole win from
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international trade.
When an economy opens up to trade and it turns out that the world price is higher than the domestic equilibrium price, which means that the country has a comparative
advantage, the country and producers of the good in question certainly do benefit. Now the world price becomes the price of the good not only in the world but also in the domestic market. This means that producers can raise their price and not lose
customers because they can export as much as desired into other countries, which is what they do, however consumers now have to face a higher price domestically and some of them do not want to produce at the higher price therefore consumers lose some of their surplus, yet the extra surplus that the producers get more than compensates for the loss and the country as a whole experiences gains from trade.
If it turns out that the world price is lower than the domestic equilibrium price it is bad news for producers since some of them will not be able to produce the same quantities at a new lower world price and they will lose some of their surplus. On the other hand the consumers will not be able to buy more at the lower price and their surplus shall increase. As a whole the country will benefit because the surplus gained by consumers will outweigh the losses of producers and there will be more gains from trade for the country.
A government may want to protect its disadvantaged producers by imposing a tariff on imports. This is simply a tax that you make importers pay for the foreign goods when they come into the country. Of course, if the country, when stepped out of autarky, becomes and exporter then the tariff doesn’t matter, yet if it is an importer it benefits the local producers at the disadvantage of everyone else. A tariff will increase the domestic price, which will allow more domestic producers to be competitive, yet domestic consumers will reduce their demand depending on the actual price increase and buy less. This means that there will be fewer consumers to buy both local and foreign goods. Since some consumers will no longer be able to afford the good they will lose surplus and since some local producers will be able to stay in business they will gain surplus in comparison to when there was trade yet no tariff. Also the government will claim the money, raised from foreign companies through the tariff. All in all surplus will be lost and this is called deadweight loss from a tariff.
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competing on a global level with many players. Lastly with trade come new ideas and technological spill overs that can have huge benefits for the country.
9.3. The Arguments for the Restriction of Trade
It is argued that trade can be restricted in cases of job or industry protection, national security, bargaining, retaliation or infant industry protection.
There are several arguments almost always put forward by free trade sceptics in various discussions. Firstly there is the argument that a country may lose jobs if an industry is competed out by imports. It is true that that industry will lose jobs, however the workers will simply relocate to making goods for which the country has a
comparative advantage. Also there is the argument of national security, which states that if a country cannot make its own steal and has to import it this reduce its security because it may not be able to produce weapons if foreign firms refuse to sell. This is farfetched, even though economists agree that a country may in some cases have to sacrifice economic efficiency for security, this argument should not be used hastily, only in times when there is reason to believe that a country is under threat. Otherwise it will simply have a pile of weapons it doesn’t use and at the cost of consumers. Another argument is called the infant industry argument, which states that some industries may be very young and small, therefore at the time not able to compete with importers, but they may also have potential to eventually become much more profitable than foreign producers. Therefore some say they should be protected. This is first of all very
politically difficult and subject to manipulation, because it is notoriously difficult to predict which companies and industries will become successful and which won’t. Also company owners if they really believe in the company should be willing to incur losses in the first years. Thirdly some say that trade can be unfair because some countries can subsidize their industries. This is true for producers who may be unfairly competed out, but the consumers of the imported goods will greatly benefit from the subsidized price.
Also these subsidies will almost certainly be costly to the governments that impose them. Lastly some will advocate trade restrictions as bargaining chips, which can work, but it can also fail. If one country tells the other it will remove a tariff on their goods if the other country will remove theirs, this may result in freer trade, but the foreign country may also reject leaving the offering country in an uncomfortable position.
Example:
There are two ways for a country to reduce its limitations on trade. First is the unilateral approach, where one country voluntarily removes its restrictions on all countries. The other approach is the multilateral, where countries bargain on their restrictions and reduce them if another country does the same. Right after WWII the average worldwide tariff was about 40%, today it is around 5%. This is due to the
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General Agreement on Tariffs and Trade and the World Trade Organization, where countries debate and bargain on trade restrictions.
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Sometimes in an agreement between two parties there are more parties affected without consent. This is called an externality. Examples include negative externalities like pollution, but also positive ones like decreased crime rates due to education. The governed tries to decrease the negative and increase the positive externalities in various ways. Sometimes it simply regulates behaviour by giving out permits or banning certain activities and sometimes it issues corrective taxes to discourage socially damaging behaviour. In some cases those affected by externalities can solve the problem themselves. According to the Coase theorem, if parties have no costs in bargaining they will resolve the question of externalities themselves.
10.1. Externalities and Market Inefficiency
Externalities are unintended effects of some actions and they have to be taken into account when striving for market efficiency.
As we have already discussed in a basic economic model there are supply and demand curves, which equilibrate, in a specific price and quantity. The supply curves’ height depend on the costs the firm incurs to produce its goods. However if the firm has negative externalities to society, like pollution it still does not take into account these social costs. We can draw another supply curve, which would include the social cost of pollution. This curve would be above the normal supply curve and the equilibrium would therefore be at a higher price and lower quantity. What a benevolent social planner could do in this case is to try to internalize the externality by imposing tax on the firm, which well represented social cost of pollution. In this case the two supply curves would match and better represent all the costs of production. This responds to one of the 10 principles of economics, where a change in incentives leads to a change in behaviour.
On the other hand externalities can be positive like those of education. Not only will educated people be good at their jobs and earn higher incomes they are also less likely to commit crimes and more likely to be informed and responsible voters. Therefore the value of education to society is higher than the one expressed purely in monetary terms, therefore the true demand curve is above the normal model demand curve, which means that the socially optimal equilibrium is at a higher quantity. So the benevolent social planner should act in reverse and subsidize the good, like governments subsidize education to various degrees all around the world.