2013-03-16

Frictions, Subsidies, and Taxes

One of the things I learned in my high school AP Microeconomics class was that a tax causes the supply curve to shift to the left, making the equilibrium quantity decrease and price increase. Consumer and producer surplus both decrease, but while government revenue can account for some of the loss in total welfare, some part of total welfare gets fully lost, and this is what is known as deadweight loss. I didn't have a very good intuition for how this worked at the time (though I was able to get through it on homework, quizzes, tests, and the AP exam). At the same time, though, I thought that a tax should be fully reversible by having the government subsidize producers, and that as this would be the opposite of a tax, supply would shift to the right, the equilibrium quantity would rise and price would fall, and there would be a welfare gain.

Then, when I took 14.01 — Introduction to Microeconomics, we again discussed the situation with a tax. Then we talked about subsidies, but I was confused because the mechanism seemed to be in providing a subsidy to consumers rather than to producers. My intuition at that point was that taxes were creating deadweight loss because producers who wanted to produce and consumers who wanted to consume near the original equilibrium could not do so after the tax, so some transactions were essentially being prohibited. However, I still didn't quite understand why a subsidy would create deadweight loss, because it seemed to me like consumers who wanted to consume more and producers who wanted to produce more than the original equilibrium quantity could now do so, meaning it seemed to me like more transactions were being made possible. That said, I did understand why the government would never subsidize producers: unless the market is perfectly competitive, producers would rather collude and pocket their subsidies while keeping prices high when they can. On the other hand, consumers prefer consuming, so subsidizing consumers is a more surefire way of increasing the equilibrium quantity, even though the price would go up rather than down.

(In 14.04 — Intermediate Microeconomic Theory, we barely touched on deadweight loss in the way that it is covered in more traditional microeconomics classes.) Now, in 14.03 — Microeconomic Theory and Public Policy, I think I better understand the intuition behind deadweight losses stemming from taxes and subsidies, and why a subsidy is not the opposite of a tax. In a tax, the government might try to target some new equilibrium quantity below the original one, so the tax revenue collected, which increases total welfare, is the difference between the willingness of consumers to pay and the willingness of producers to accept at that quantity multiplied by that quantity. Consumer and producer surplus both decrease, and the tax revenue contribution to the increase in total welfare is not enough to offset these two, so there is an overall deadweight loss. A completely isomorphic way of picturing this is by considering the tax falling on consumers so that the demand shifts to the left; in both cases, the equilibrium quantity drops, the government collects its revenue, surpluses drop, so deadweight losses appear.
Meanwhile, for a subsidy, the government might target a higher quantity than the original equilibrium. The spending on that subsidy is the difference between the willingness of producers to accept and the willingness of consumers to pay at that quantity multiplied by that quantity. Consumer and producer surpluses both increase, but together they do not increase enough to offset government spending which is an overall drain on total welfare, so there exists a deadweight loss.

It's interesting that taxes and subsidies are not opposites. The intuition is that for a tax, the revenue is not enough to compensate for the welfare losses of consumers and producers because the new equilibrium quantity is lower. By contrast, for a subsidy, the spending is too high compared to the welfare gains of consumers and producers because the new equilibrium quantity is higher. It looks like it is not possible to spend money given by tax revenue to undo the effects of a tax; instead, the government can only overshoot and overspend. It reminds me very much of how friction works: moving in one direction on a surface with friction causes energy loss, while turning around to move in the other direction on that same surface most certainly does not cause energy gain. Essentially, in this model, the market is frictionless, and the government introduces friction.

Of course, this essentially contradicts Keynesian models of government taxation and spending and their respective effects. That's why care must be taken when putting microeconomic models in a macroeconomic perspective. This also doesn't consider externalities, less than perfectly competitive market structures, et cetera. Anyway, I hope my musings on this may help give other people some intuition on simple issues of deadweight loss in microeconomic theory.

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