Effect Of Taxation On Demand And Supply Of Goods

Ad valorem tax on demand and supply of goods

The supply curve of these items on the retail level is perfectly elastic. A perfectly elastic supply is one where a negligible change in price is associated with a very large change in supply. The supply curve is parallel to the horizontal axis. The perfectly elastic supply curve for these items are shown as SS. The initial demand of the household is perfectly inelastic. Household facing perfectly inelastic demand curve cannot change their demand even when price changes (Fine 2016). In this the demand curve is parallel to the price axis. The perfectly inelastic demand curve is shown as DD. The equilibrium is obtained at point E. Corresponding equilibrium price is P* and equilibrium quantity is Q*. Now, imposition of ad valorem tax collected on retailers will shift the supply curve upwards from SS to S₁S₁ by the tax rate. The new equilibrium is at E_1. Price paid by the buyers, increases to P_1. This is the tax inclusive price.

The division of tax burden depends on the elasticity of supply and demand. Higher the elasticity lower is the tax burden and vice versa. The seller of these items have a perfectly elastic supply curve meaning supply can change infinitely in response to price (Katz 2016). Buyers because of inelastic nature of demand cannot reduce their demand. Therefore, sellers bypass the entire tax burden to buyers.

If there were 9.6 million households in Australia during 2017-18, then the tax would raise a total of (46.54233*9600000) = $ 446806368.

A progressive tax is one where tax rate increases along with taxable amount. In case of regressive tax the tax rate decreases with increase in taxable amount. In the given scenario, the tax rate does not alter depending on the level of spending. The rate remains same irrespective of the taxable amount. Therefore, the tax is proportional.

The own price elasticity is given as -0.90. Therefore, in response to a price increase by 0.20 demand for soft drinks, energy drinks and cordials will decrease by (0.20 *0.90) = 0.18 that is 18% point.

The average household will reduce their spending on soft drinks in a week  by 3.58-(3.58*0.18) =  2.9356

The spending inclusive of tax is = 2.9356 + (2.9356*0.20) = 2.9356 + 0.58712 = 3.52272.

The spending in a year  = (3.52272 *52.1775) = $30.63445

New tax revenue with price elasticity of -0.90 = (38.16471 *9600000) = $366381222

In 2017-8, the tax would raise a revenue of $366381222 

Division of tax burden and elasticity effect

As all the taxes can be fully passed to the consumers, the entire tax burden is borne by the buyers. The ad valorem tax (A) is placed on retail price of SSBs, volumetric tax is imposed on per lit of SSBs and content tax (C) is imposed on per 100 gram of SSB. As obtained from the table, for first SSB price under ad valorem tax increases by 0.2.under volumetric price increase is 0.3 and for Content tax it is 0.4. Therefore, those who pay content tax will reduce their demand at most followed by those under volumetric and ad valorem. The same pattern is observed for all the SSBs. Price increases the most under tax C. Price increase is higher for tax B than for tax A. As own price elasticity is same for all the SSBs, change in demand solely depends on proportionate increase in price. Sales and consumption will be reduced comparatively less for tax A than those for tax B and C.

In general, price impact is the highest for content tax. Consequently, the possible demand reduction in this group will be highest based on the own price elasticity. Tax revenue depends on the extent of price increase and that of the change in demand. The difference in demand adjustments in turn compensated by the difference in proportionate price increase yielding same tax revenue for all the group.

Budget constraint

Public school 

Private school 

Household demand function for private education (X) and other goods (Y)

Comparing utilities obtained from private and public education, it has been observed that only household type I will send their child to public school as by doing so it receives a higher utility

(60189 > 59102). Rest of the three household will send their child for a private education.

The schemes suggest to provide government assistance in forms of a voucher where price for every unit of education is $1. In order to understand whether households are better off with this new schemes with a higher affordability of education, the demand for education and corresponding utility level of utility is compared under the three system- free public education, private education and that under new voucher system.

 As shown from the above table, when household wants completely free education then they demand 12000 unit of education. For private education with a subsidized price of $0.80, the education demand for all the four type of household is higher than that under new voucher schemes. For first household education demand under new schemes is 8000. This is still lower than free public school education unit

Budget constraint and education expenditure

When the utility level is compared it is observed that, the utility level under the new either same or greater for II, III, IV type of household. However, for type I, utility level is lower under new schemes because of a lower education demand. So far as private education is concerned the utility level is no better under new schemes for all the four household types.

The analysis of demand and utility suggests that the new system is though better than free and restricted amount of education demand for some household but in general the existing system is more effective in terms of education demand. 

The consumption leisure model is a microeconomics model for choice between consumption and leisure. In the model it is assumed that consumers derive utility from two goods- leisure and consumption good. Both are assumed to be normal good. The choice between consumption and leisure is limited by the budget constraint (Baumol and Blinder 2015). Change in the effective wage rate has an impact on both choice of work hours and leisure. Given fixed number of hours in a day, an increase in work hours implies a decrease in leisure time and vice-versa. In response to a cut in tax rate, the effective wage changes as well. The wage effect can be further divided into income and substitution effect. The ultimate impact on tax cut on work hours depend on the magnitude of income and substitution effect.

The two figures below describe the two possible case for the effect of a cut in top marginal tax rate. wage line or income constraint is given as WT. The initial utility level is given by the indifference curve I_1. The initial equilibrium is at E_1. Corresponding to the equilibrium, the leisure hour is given as OL₁ and work hours is TL_1. Now suppose, there is a reduction in to marginal tax rate. This will shift wage line from WT to W₁T. The new equilibrium is at E₂. With a reduction in the tax rate, for every unit of work hours’ workers now earn a higher wage (Mahanty 2014). This increases the cost of leisure. As the price of leisure increases, workers now substitute leisure with more work hours. This is the substitution effect of tax cut. However, with an increase in effect income worker now can get their needed consumption good at less work effort. This encourages them to take more leisure. This is the income effect of a cut in tax rate. Income effect thus tends to reduce labor supply while substitution effect tends increase labor supply (Goodwin et al. 2015). Workers for whom substitution effect is larger than income effect, labor supply increases while workers for them income effect is larger than substitution effect the labor supply reduces.

Choice between consumption and leisure

In order to decompose wage effect into income and substitution effect, the money income is first reduced by compensating variation in income (Young and Hickman 2015). For this, the additional income is taken back so that the individual can reach to the original indifference curve I_1. The wage line obtained after compensating income variation is W’T’. This is tangent to I₁ at E_3. For both figures, movement from E₁ to E₃ is associated with higher work hours. This shows the substitution effect. The movement from E₃ to E₂ is the income effect. In figure 2. Income effect dominates and hence, work hours reduces from TL₁ to TL₂. In figure 3 however substitution effect dominates causing an increase in work hours from TL₁ to TL_2. 

If workers cannot alter their work hours then after the tax cut, then their choice of work hours and leisure remain same even after the change in tax rate. As worker continue to out same work effort they will enjoy a higher effective income and hence will be better off by their increased affordability (Friedman 2017). 

WT is the initial wage line. The initial indifference curve is I₁. The equilibrium is at E_1. At the equilibrium workers supply TL₁ work hours and enjoys OL₁ leisure hours. Now when there is a tax cut then wage line shifts pivotally to W₁T.  With fixed hours of labor TL_1, workers will now reach to a higher indifference curve I_2. The new equilibrium point is E_2.

If the workers are able to change work hours then some workers might decide to increase their work hours and hence earn a higher income. The higher income might enable them to enjoy more consumption goods and hence, enjoy a higher utility (Cowen and Tabarrok 2015). However, this comes at the cost of reduced leisure. The other might chose to derive additional utility from increased leisure. The flexibility thus enable workers to derive higher utility either by increasing work hours or by increasing leisure time and hence, workers would be better off.

1. i) Real wage is the inflation adjusted wage rate. It is obtained by dividing nominal wage by the price level (Nicholson and Snyder 2014). An increase in real wage means a higher affordability for consumers. The increases wage actually increases price of leisure increases. An increased real wage encourages workers to put greater work effort. With a higher income they can increase their standard of living. The substitution effect is stronger than income. The desire to increase their living standard can be a possible cause of increasing full time work hours.
2. ii) Income taxes are compulsory payment made to the government based on the level of income. Income tax reduces the effective return from work effort. A reduction in income tax rate thus increases effective income. Workers when get higher return from the work effort might encouraged to put more work effort.  

iii) In economics, consumerism is defined as a situation increasing consumption of goods is appeared as economically desirable. Increased consumerism therefore means people’s willingness towards consumer goods increases (Ashwin, Taylor and Mankiw 2016). In order to increase consumption, income needs to be increased. The desire to consumer more in turn encourage workers to increase their work hours and earn a higher income. 

The decision whether to purchase insurance or not that depends on the individual’s perception of risk and resulted expected utility from participating in an activity. Suppose an individual has wealth W. Utility is the function of wealth. Now, the individual will be identified as risk averse if expected utility of the wealth is less than utility derived from expected wealth. Reverse is the case for a risk lover individual (Mankiw 2016). A risk neutral individual is indifferent between the two situations. A risk averse individual always wants to purchase full insurance.

The house of Fei Hong and Saanv faces the risk of bush fires. The expected utility however is different depending on their wealth level. The expected utility of the house to Fei Hong may be lower than utility of the expected wealth (Moulin 2014). Therefore, Feig Hong wants insurance. For Saanvi however the expected utility from the house might be greater than that derived from wealth derived after payment of insurance premium.

Farooq’s expected annual income

ii) Farooq’s expected utility

iv)The minimum insurance premium that the company should charge is equivalent to the expected loss of the company.

Now,

Therefore, the minimum premium that a company offering crop protection to Farooq is 640.

v) Expected income of Farooq, E (X) = 5760

Expected utility of Farooq is, E (U) = 72

Certainty equivalence is the amount such that a consumer is indifferent between taking a risk and receiving certainty equivalent amount.

The certainty equivalent (CE) therefore yield a utility equivalent to the expected utility of Farooq.

Diversification is a strategy by which individual makes exposure to many risky events rather than only a few or one risky venture. By diversification individual aims at dividing risk at into smaller amount. This allows risks to be repeated overtime. This smooths out good and bad outcome such that expected outcome is to be achieved.

If Farooq can divide his field in two halves A and B

Then, expected utility from field A is

Expected utility from field B is 

Total expected utility after diversification 

Expected utility without diversification is 72.

Expected utility with diversification is 101.82.

As the expected utility is from dividing the potato field into two adjacent halves is greater than the expected utility from farming the field as a whole, Farooq would definitely divide his field in two and will minimize the risk of crop failure.

vii) The correlation between two risky events play an important role in deciding whether to diversify or not. In case of perfect positive correlation good outcome of one event comes with good outcome of other and bad outcomes is associated with a bad outcome. Now, of risk or gain associated with field A and field B are perfectly positively correlated standard deviation of risk of the potato field is the same as the sum of risk of two fields

SD (A+B) = SD (A) + SD (B)

Therefore, diversification would be worthless. 

References 

Fine, B., 2016. Microeconomics. University of Chicago Press Economics Books.

Katz, J., 2016. The macro-and microeconomics of natural-resource-based growth. Neostructuralism and heterodox thinking in Latin America and the Caribbean in the early twenty-first century. Santiago: ECLAC, 2016. LC/G. 2633-P. p. 223-237.

Baumol, W.J. and Blinder, A.S., 2015. Microeconomics: Principles and policy. Cengage Learning.

Mahanty, A.K., 2014. Intermediate microeconomics with applications. Academic Press.

Goodwin, N., Harris, J.M., Nelson, J.A., Roach, B. and Torras, M., 2015. Microeconomics in context. Routledge.

Young, D.R. and Hickman, J., 2015. Microeconomics for Public Policy.

Friedman, L.S., 2017. The microeconomics of public policy analysis. Princeton University Press.

Cowen, T. and Tabarrok, A., 2015. Modern Principles of Microeconomics. Palgrave Macmillan.

Nicholson, W. and Snyder, C.M., 2014. Intermediate microeconomics and its application. Cengage Learning.

Ashwin, A., Taylor, M.P. and Mankiw, N.G., 2016. Business economics. Nelson Education.

Mankiw, N.G., 2016. Economics-Microeconomics-Principles of Microeconomics.

Moulin, H., 2014. Cooperative microeconomics: a game-theoretic introduction. Princeton University Press.

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