A specific tax is a fixed dollar amount that must be paid for each unit bought or sold. An ad valorem tax is a tax that is stated as a percentage of the good's price.
The effects of a tax are independent of who is legally required to pay it, whether buyers or sellers.
A tax lowers the amount of a good bought and sold, raises the total amount that buyers pay per unit, and lowers the amount that sellers receive per unit. It also causes a deadweight loss because some units that buyers value more than the cost of production are not produced.
The economic incidence of a tax depends on the shapes of the demand and supply curves. The more elastic is demand and the less elastic is supply, the smaller the share of the tax borne by consumers. For small taxes, consumers' share of the tax is Es/(Es- Ed).
Consumer surplus and producer surplus both fall because of a tax. The sum of these losses is greater than the government's revenue from the tax. The difference between the two amounts is the deadweight loss.
To minimize the deadweight loss from taxation, goods that have more inelastic demands and supplies should be taxed more heavily than other goods.
A subsidy is a payment that reduces the amount buyers need to pay or increases the amount sellers receive. Subsidies increase the amount of a good bought and sold.They also create a deadweight loss, because some units that consumers value less than the cost of production are produced and consumed.
Policies designed to raise prices
A price floor establishes a minimum price that sellers can charge. If it is above the equilibrium price without the floor, sellers will want to supply more than buyers are willing to purchase at that price. In principle, a price fl oor may either raise or lower sellers' total profits.
A price support program raises the price of a good by increasing the demand for it. Price supports can result in the government buying units for which it has little or no use.
A production quota imposes limits on the amount of a good that individual firms can produce.
A voluntary production reduction program offers firms an inducement to voluntarily reduce their production.
All these ways of raising the price create a deadweight loss. The price support policy creates the largest deadweight loss; the other programs create the same deadweight loss (assuming that quotas are distributed efficiently or can be traded and that production is efficient with the price floor).
Sometimes governments instead want to lower the price of a good. A price ceiling is one example of a policy that governments use for this purpose. With a binding price ceiling, sellers will want to supply less than buyers are willing to purchase at the ceiling price. The equilibrium quantity falls, creating a deadweight loss.
Import tariffs and quotas
A tariff is a tax on imports. A quota places direct limits on the total amount of a good that can be imported.
Domestic aggregate surplus is the sum of consumer surplus, domestic firms' producer surplus, and government revenue.
If the import supply curve is horizontal at the world price (that is, if it is infinitely elastic), a tariff will lower domestic aggregate surplus.
An appropriately chosen quota can produce the same market equilibrium as a tariff. The only difference is that the government does not receive any revenue with a quota (unless it sells the rights to import the good). Instead, foreign firms lucky enough to import their goods receive the benefit.
If the import supply curve is upward sloping, a tariff (or quota) can increase domestic aggregate surplus.
