The Utility Maximization Rule: The consumer should allocate his/her resources (money income) so that the last dollar spent on each product yields the same amount of extra, marginal utility. Rule: MU of product A = MU of product B = MU of product C, D, E, etc…P of A P of B P of C, D, E, etc…Tax Incidence and Deadweight Loss Quantity Price D S S1 Qe Qt Pe Pb Ps DWL Producers’ tax burden Consumers’ tax burden
© Jason Welker 2009 Zurich International School 5xPe = Price at equilibrium, pre-tax xQe = Quantity demanded and supplied before tax xPb = Price buyers had to pay after the tax xPx = Price sellers received after the tax xQt = Quantity demanded and supplied after the tax xBlue box = Amount of tax born by the consumers in the form of lost consumer surplus xYellow box = Amount of tax born by producers in the form of lost producer surplus. xCombined area of Blue and Yellow boxes = Tax Revenue xGreen box = DWL is the total efficiency lossthat results from an under or over-allocation of resources towards the production of a good or service Why would the government impose a tax on a good such as above? Doesn’t it only lead to a disequilibrium and thus an under-allocation of resources towards the goods production? Yes, but what if this good creates negative externalities? What if S1 is closer to the MSC (Marginal Social Cost) curve whereas S is the MPC (Marginal Private Cost) curve? In these cases, a tax may be used to correct a market failure (such as second hand smoke or air pollution). Excise taxes like this also may be levied on goods simply to raise revenue to fund government spending (such as a new light rail system or other public or quasi-public goods). Tax incidence and elasticity: Remember, if Demand is highly inelastic then consumers will bear the brunt of the tax burden (i.e. cigarettes and gasoline). If Demand is highly elastic then producers will bear the brunt of the tax burden. Be able to graph and explain tax burden with different Demand and Supply price-elasticities. Costs of Production: You must understand the difference between explicit and implicit costs. xImplicit: the opportunity cost of employing self-owned resources toward one activity rather than another (includes NORMAL PROFIT) xExplicit:the money costs of employing resources owned by others, in the form of wages, rent and interest. Costs Quantity AFC AVC ATC MC
© Jason Welker 2009 Zurich International School 6Other things to remember about costs: xTotal cost (TC) = Fixed costs (FC) + Variable costs (VC) xATC = AFC + AVC xThe distance between ATC and AVC represents AFC (which always declines as output increases b/c costs are “spread out”). xAVC is significant for firms to consider, b/c if price ever falls below AVC, the firms best option is to shut down, since it is no longer covering its fixed costs. It would minimize losses by shutting down!