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4.8.3TAX INCIDENCE

Tax incidence focuses on who ends up paying taxes. In the case of Figure 4.16 we see that when a tax is imposed the effects in equilibrium lead to a reduced level of output but at an increased price. The post-tax price of P2 is higher than the pre-tax price of P ; however, the price has not increased by the entire amount of the tax. A portion of the tax is paid by consumers via higher prices, but some of the tax is also absorbed by the producers. The incidence of tax falls approximately 66% on consumers (prices are 66% higher) and 34% on producers. Consumers pay £13.20 of the tax on each unit with producers absorbing the remaining £6.80.

The tax incidence or the degree to which taxes are paid by producers or consumers depends on demand and supply conditions reflected in demand and supply curves. Consider the case shown in Figure 4.17. In Figure 4.17 panel A, a tax has been imposed (the same amount as in Figure 4.16); however, the demand curve in this case is quite flat, indicating relatively higher consumer responsiveness to price changes.

The outcome after the tax is imposed is similar to the previous case. The supply curve moves left or upwards and a lower equilibrium quantity, Q3, is produced at a higher price, P3. The tax revenue generated for the government is shown as the shaded rectangle. With similar supply conditions, and the imposition of the same tax (£20 per unit), but a flatter, more price elastic demand curve the increase in equilibrium price is less than in Figure 4.16. The quantity decline is greater and the tax incidence is not the same. Here the tax incidence falls more on producers than consumers as the price consumers pay has risen from P to P3 which is approximately 40% of the tax (£8 per unit); hence producers absorb the difference of 60% (£12 per unit). If Q3 is 20 000 units, the tax revenue collected is £400 000.

If suppliers did not absorb a large proportion of the tax, the fall in equilibrium quantity would be much larger, as shown in Figure 4.17 panel B. Here the demand

A			B
P	S2		P
		S1	P4
P3
P^	D		P^
					D
Q3	Q^	Q	Q4	Q^	Q

F I G U R E 4 . 1 7 T A X I N C I D E N C E

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curve is presented and the pre-tax price P is shown along with P4 where P4 represents the tax-inclusive price that would prevail if suppliers passed on the full cost of the tax to their customers. The quantity on the demand curve corresponding to the full tax-inclusive price is Q4. The quantity Q4 is substantially less than Q or Q3. Thus, suppliers react by absorbing some of the tax because they know their market and appreciate how price-sensitive their consumers are.

The more price-sensitive consumers are, ceteris paribus, the greater the proportion of a tax that suppliers are willing to absorb. High price-sensitivity is reflected in a relatively flat demand function.

4 . 9 S U M M A R Y

•The contribution of the business sector (the supply component of the demand and supply model) within the economic system is substantial.

•We assume firms operate in order to maximize their economic profits.

•Firms decide on the amount to produce and what price to charge for their output to maximize their profit. A useful distinction for examining some of the most important decisions firms must make is between shortand long-run decisions.

•To decide on the profit-maximizing level of output requires some analyses of the general patterns exhibited by firms’ costs and revenues, i.e. total, average and marginal.

•A supply-side welfare perspective is possible by examining the concept of producer surplus.

•Economic decision-making by suppliers in response to price changes can be analysed using the price elasticity of supply.

•Firms’ investment behaviour has a direct bearing on both the state and growth of a country’s capital stock. Several factors feed into firms’ investment decisions.

•Governments affect firms’ supply decisions in many ways. Examples presented here refer to subsidies, shown here for an industry where international trade is conducted, and environmental taxes. Both are analysed using the Demand and Supply framework.

•The effect of government intervention when taxes are imposed can be analysed using the tax incidence approach.

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R E V I E W P R O B L E M S A N D Q U E S T I O N S

1.Identify which of the following are short-run decisions and which are long-run decisions for a business. Explain your rationale in each case.

a. hiring one extra worker,	c. building an extension to a factory,
b. buying a new computer,	d. producing 20% more output.

2.Grandon’s Nursery sells roses and their demand curve is presented below.

a.Compute total and marginal revenue that correspond to the demand information in the table below.

b.Sketch the company’s demand, total revenue and marginal revenue curves.

Price Demand Total Revenue Marginal Revenue

20 0

15 25

12.5 37.5

10 50

7.5 62.5

575

0100

3.Information on Grandon’s costs are presented below.

a.Using the table below and data from question 2, decide on the profitable level of output for the firm. Hint: you need to compute marginal costs.

b.Sketch marginal revenue and marginal cost on one graph.

Output Total costs Average cost Marginal cost

0100

25	325
37.5	337.5
50	425
62.5	525
75	750

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4.a. If Grandon’s fixed costs are £80, compute Grandon’s Average Fixed Costs and Average Variable Costs.

b.Graph Total Average Costs, Average Fixed Costs and Average Variable Costs on one graph. Comment on how the three sets of costs are related.

5.Given the profitable level of output for Grandon’s you chose in question 3, what price should the firm charge for its roses?

a.Does the firm earn profits at this price?

b.Are supernormal profits earned?

c.Explain if the firm should charge either a higher or lower price.

6.Consider that Grandon’s can produce their profit-maximizing level of output.

a.How would you expect Grandon’s to react in terms of their supply if they could increase the price they receive by 12.5% in one month’s time?

b.How would you expect Grandon’s to react in terms of their supply if they could increase the price they receive by 12.5% in six month’s time?

7.As part of a government policy to boost the horticultural industry, a subsidy is to be paid to all nurseries growing organic products. Grandon’s nursery receives a subsidy of 12.5%.

a.Show, using a diagram, the effect of the subsidy on Grandon’s supply of roses.

b.What is the impact of the subsidy on Grandon’s equilibrium price and quantity of roses?

c.Do you think this policy makes good use of the resources available to the Government?

8.Read the following brief case study and answer the questions that follow.

The grey market for cars

Based on the principal of comparative advantage, economists agree that free trade improves welfare. An example of trade is the substantial number of cars, both used and new, imported into the EU each year, which are known as grey or parallel imports. Such grey imports are a feature across many different product markets. Parallel imports/grey imports occur where the goods of a particular producer are imported into a particular territory by a third party in competition with the licensed distributor in that territory. They are called grey imports in allusion to the ‘black’ market as grey products are sometimes considered to be legally questionable. Producers are usually not in favour of grey imports citing that goods that are distributed through ‘normal’ distribution channels are targeted and correspond to the needs of buyers in the markets for which they are designed.

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Consumers are sometimes happy to buy grey products because they cost less than ‘the real thing’ but problems can occur later when they realize that grey products may not meet the standards of the same product that was designed for their market. This is certainly the argument put forward by car manufacturers and there are countless examples of issues relating to grey car imports: lack of warranty – because the specification of the car is different for different markets, failure to meet national emission standards, fewer features, failure to meet crashtest standards of domestic cars, etc. Consumers argue that because suppliers try to charge different prices for the same product in different countries (see the case study at the end of Chapter 3), the consumer is right to attempt to source the product legally from another market.

Governments appear to be unable to agree on a consistent approach to the resolution of whether parallel imports are justified or not. Therefore, it is left to intellectual property rights to determine the position (intellectual property refers to intangible property that includes patents, trademarks, copyright and any registered or unregistered design rights).

a.Use demand and supply analysis to consider how trade has an impact on welfare – consider the affects of trade on both consumer and producer surplus.

b.Show, using demand and supply analysis, the impact of grey imports on the market for standard (non grey-import) cars.

c.Why do you think suppliers (car manufacturers) are unhappy with grey imports – are they not still managing to sell their cars?

F U R T H E R R E A D I N G A N D R E S E A R C H

There is a rich variety of accessible academic research on supply, firms and firm behaviour. A brief selection is cited below, all of which are worth reading, but which focus on different aspects of firms’ purpose or functions in the economic system.

Coase, 1937; Williamson, 1991; Jensen and Meckling, 1976; Foss, 1997; Penrose, 1955.

R E F E R E N C E S

Coase, R. (1937) ‘The nature of the firm’, Economica, 4, 386–485.

Foss, N. (1997) ‘Austrian insights and the theory of the firm’, Advances in Austrian Economics, 4, 175–198.

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Jensen, M. and W. Meckling (1976) ‘Theory of the firm: managerial behavior, agency costs, and ownership structure’, Journal of Financial Economics, 3(4), 305–360.

Penrose, E. (1955) ‘Limits to the growth and size of firms’, American Economic Review, 15(2), 531–543.

Williamson, O. (1991) ‘The logic of economic organization’, in Williamson, O. and Winter, S. G. (eds), The Nature of the Firm – Origins, evolution, and development. Oxford University Press.

C H A P T E R 5

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M A C R O E C O N O M Y

L E A R N I N G O U T C O M E S

By the end of the chapter you should be able to:

Explain how income and resources circulate in an economy between consumers, firms, government, financial and international sectors using the circular flow of income model.

Describe and sketch the business cycle of short-run output trends.

Discuss causes of business cycles and their implications for government and business.

List the components of real output.

Compare alternative approaches to measuring ‘real’ economic activity: relating personal income and national output/product.

Apply the aggregate demand (AD) and aggregate supply (AS) model to:

•determine equilibrium economic activity and aggregate prices;

•analyse how changes in aggregate demand and supply affect equilibrium.

Apply the concept of the multiplier to assess the effect on equilibrium economic activity of changes in planned expenditure.

Examine government’s effect on economic activity via government expenditure, budget, deficit and debt.

Apply a production function approach to analysing economic activity.

5 . 1 I N T R O D U C T I O N

Economic activity for an economy is the outcome of the various decisions taken by consumers (households), firms at home and abroad, and government; in other words the sum of C + I + G + (X − M ). When the value of economic activity is analysed over time, it follows a cyclical pattern in the sense that short periods of growth in economic activity have been followed by periods of contraction and the pattern is observed across all developed economies over the last century.

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One approach to examining economic activity is to consider the flow of income generated within an economy over a specific period such as a year, a quarter, a month, etc. using the circular flow model as presented in section 5.2. This allows for analysis of the various sources and destinations of flows of income and resources around an economy. From analysis of such income flows over time, short-term fluctuations in economic activity are evident and are referred to as the business cycle, which is examined in section 5.3 (economic growth over the longer term is considered separately in Chapter 9). Economic debate on the possible causes of the cyclical pattern in output is also addressed.

The components of economic activity defined according to expenditure categories (C + I + G + [X − M ]) are considered in section 5.4 and alternative measures of economic activity based on value-added and income methods are also presented. In section 5.5 a model is introduced that helps to understand how macroeconomic equilibrium economic activity is reached. Using this model of aggregate demand and aggregate supply the equilibrium effects of changes of either aggregate demand or supply can be considered. In section 5.6 the multiplier – an important feature of this model – is examined in some detail. This analysis provides information as to how changes in expenditure have repercussions in an economy that can give rise to changes in equilibrium output and prices. The contribution of international trade in economic activity is examined in section 5.7. In section 5.8 an alternative and equally valid model for considering aggregate economic activity is presented and its main features are discussed.

5 . 2 E C O N O M I C A C T I V I T Y A N D T H E C I R C U L A R F L O W

Economic activity over any period is the result of all the decisions of the many different economic units in an economy over that period – consumers (households), firms at home and abroad, and government. Production and consumption are the results of the various transactions between these groups, as they buy and sell their goods and services, labour and financial assets. These transactions are shown in Figure 5.1.

The circular flow denotes all transactions in the economic system describing how products, services, resources and money flow around the economic system.

Beginning with the market for products and services, we see that goods and services flow from firms to households (consumers). In payment for the goods and services money flows from consumers back to firms. The government also buys some goods

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Market for		£	for goods and services (G&S)
domestic
products and
						Goods and services (G&S)
services

	Taxes	Government	Taxes
Savings	Households		Firms	Investment
	G&S		G&S
Domestic	TP*		£ G&S
market for
resources	Resources
International			£ for resources
market for
products/	Imports	Foreign	Exports
services/
	£ for imports	markets	£ for exports
resources

F I G U R E 5 . 1 T H E C I R C U L A R F L O W O F I N C O M E , R E S O U R C E S A N D O U T P U T

TP denotes transfer payments, explained further below.

and services from firms and pays for them while the government also provides some goods and services to households, which are partly paid for in the form of taxes paid to it by households and firms. Many of the goods provided to households by government are called public goods, as outlined in Chapter 1. When government provides goods or services that the private sector is unwilling to provide, this is known as market failure since the market incentives do not exist that entice private firms to supply (this issue is further discussed in Chapter 6).

An additional transaction involves the government making transfer payments to households. These are payments made to individuals who are not part of the production process, i.e. they do not supply either capital or labour to the economic system. These payments include unemployment benefit, pensions, disability payments, income supplement programmes and subsidies. They are called transfer payments since the government transfers some of the money paid to it by firms and consumers (via taxes) to those who qualify for the payments due to their age, level of income, or economic status. Incidentally, to avoid counting transfer payments twice in national income, the receipts of the government count in national income, since they are derived from the income of individuals and firms, but not the transfer payments themselves.

Moving to the market for resources, this refers to the various factors of production used by firms to produce their output. For example, households supply their labour

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resource to firms and receive payments in return. Out of households’ savings in banks and other financial institutions, firms can also borrow and thus some firms’ capital is also derived from households’ resources.

The final set of transactions conducted in the circular flow involves foreign markets. Imports are purchased from foreign markets and payments are sent to the foreign markets to pay for them and finally exports are sent to foreign markets and payments are received for them.

In the circular flow of income, injections of income into the flow include:

•investment expenditure by firms;

•government expenditure;

•income earned as payment for exports.

Leakages of income out of the circular flow include:

•savings;

•taxes;

•income paid for imported goods.

Although not mentioned explicitly in Figure 5.1, the financial sector, which consists of banks and various national and international financial institutions, plays a role in facilitating transactions within the economic system. The role of this sector in the economic system is considered in more detail in Chapter 7.

Underlying the two-dimensional representation of the circular flow in Figure 5.1 are all the varied and complex institutions that support and underlie its activities. These include (in no specific order) the local, domestic and international financial systems, systems of corporate governance, legal and political environments, social and cultural background, technological capability and the myriad standards, business and personal ethics, and codes of conduct that are embedded in the economic system. Keeping these in mind helps us to better understand the functioning of the various resource, factor and money markets that are outlined in the circular flow diagram.

5 . 3 R E A L O U T P U T A N D T H E B U S I N E S S C Y C L E

Economies across the world appear to follow cycles in their production.

Graphing countries’ output over time reveals business cycles – a tendency for real output to rise and fall over time in a reasonably regular pattern.

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As explained in Chapter 1, economists focus on real output because it provides a more accurate picture of how much an economy produces in quantity terms over time than the actual or current value of output. Quoting values in real terms effectively means that the effect of price changes is removed and only quantity or real effects remain.

Examining real output trends in Figure 5.2, we see that periods of growth in real output are followed by declines in growth. There are periods when real output

A: Business cycle

Business cycle: short-run

Real

One

Boom

fluctuations in real output

output

cycle

Trend line: long-run

Boom

Peak

growth in real output

Recession Recession

Trough

Time

Contraction Expansion

B: International business cycles

	14
			France
	12
	10		Germany
growth
	8		Ireland
output
	6		Japan
Real	4		United
%	2		Kingdom
			United
	0		States
	1970 1972 1974	1976 1978	1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
	–2
	– 4

F I G U R E 5 . 2 P A T T E R N S I N R E A L O U T P U T – T H E B U S I N E S S C Y C L E

Source: (Panel B) International Financial Statistics of the International Monetary Fund

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grows quickly and when this growth slows down in a cyclical fashion. The length of a business cycle is measured from peak to peak (also described as boom to boom) where peaks imply the summit of growth of real output. Following a peak/boom although growth remains above its long-run trend for a period, it eventually begins to slow down or contracts. Over time the growth rate falls below the long-run trend and the contraction becomes a recession (trough). The next phase corresponds to the growth rate expanding and ultimately the expansion brings the economy into another boom. Over the course of a business cycle, firms are not always operating at full capacity as there is not always sufficient demand to meet their planned supply. The business cycle is a shortto medium-term phenomenon and usually, although not always, booms (periods of high or fast growth) or recessions (periods of slow or sometimes negative growth) last months rather than years.

In comparing Figure 5.2 panels A and B it is clear that observed business cycles are not as regular as the stylized or model case. However, we see that booms are invariably followed by recessions although the regularity varies from cycle to cycle. From examining the average periods for economic expansions and contractions, economists have concluded that economies spend more time in the expansion phase (lasting three to five years) rather than the contractionary phase (lasting around one year) of business cycles.

While business cycles are observed in the short to medium term, long-run growth follows an upward trend. A graph of real output over the last century, for example, shows that internationally real output grew on average by over 3% per annum. This means that the quantity of output produced internationally increased each year by approximately 3%. Since 3% is an average figure, growth was lower in some periods and higher in others depending on the prevailing business cycle. Sometimes output is above the long-run trend (if an economy is booming, workers may be working a lot of overtime and capital equipment may be used at more than recommended full capacity) and at other times it lies below trend. If output is below trend an output gap is said to exist.

The output gap is the difference between potential output (also known as full employment output) and actual output.

To figure out whether long-run economic growth was of benefit in welfare terms we would need to figure out whether the international population grew faster or slower than 3%. If population growth were also 3%, then the growth in output just kept pace with the population and average living standards would be unchanged. In other words people, on average, were no better or worse off (ceteris paribus). If population growth were 1%, then output growth exceeded population growth