Public Goods

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Two of the most controversial micro-economic roles of government are its role in providing public goods and its role in dealing with market failure due to externalities

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Public Goods

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Goods are either rivalrous or non-rivalrous , and are either excludable or non-excludable
Rivalrous goods are those which can be consumed by only one person at the same time -- for example, a candy bar or a suit;
Non-rivalrous goods may be consumed by many at the same time at no additional cost -- for example, national defence or a piece of scientific knowledge.
An alternative definition is that a non-rivalrous good may be provided to more consumers at a very low marginal cost for each additional consumer. The alternative is correct, since even national defence takes additional resources for each person covered (it would be cheaper not to extend the area protected to Alaska and Hawaii) and disseminating scientific knowledge does take added expense in printing journals and books. However, the marginal cost is very low compared to the cost of establishing an army in the first place or of making the scientific discovery. The alternative does leave us with the question: how low is "low enough" to qualify a good as "public"?
Excludable goods are those for which one can at low cost prevent those who have not paid for the good from consuming it. You can require people to pay for a stamp before you deliver mail or pay for a ticket before they board a train; you cannot cheaply or easily prevent people from entering a park or from listening to a radio station.
Note that excludable goods are sometimes provided publicly (mail service) and non-excludable goods (radio and television) sometimes privately.
These two distinctions (rivalrous and excludable) provide us with four types of goods:

Types of goods

xxxx	EXCLUDABLE	NON-EXCLUDABLE
RIVALROUS	PRIVATE GOODS (Candy bar)	COMMON GOODS  (Fishing grounds)
NON-RIVALROUS	PUBLIC ENTERPRISE GOODS  (TVA, mail, trains)	PURE PUBLIC GOODS  (National defense, court system)

COMMON GOODS are those which are rivalrous in consumption but non-excludable . Fishing grounds provide a good example -- fish caught by one boat reduce the catch available for others, but it is difficult to exclude fishing boats from going where they please.
Often the problem with common goods is overuse -- over fishing, overuse of rivers or the air to discharge waste.
A step towards a solution is often to define property rights which had been left undefined because of a belief (perhaps justified at an earlier time) that such goods were non-rivalrous -- that the fishing grounds were inexhaustible or the river unpollutable.'
PUBLIC ENTERPRISE GOODS are those which are excludable and so could be privately provided, but which have low marginal costs of production and so are likely to be natural monopolies. Private provision runs the risk of monopoly and hence of under provision; public provision is accordingly desirable.
Note that private provision is not impossible in these cases, so it is always debatable whether government should be in the business -- and the public choice school would argue that politicians and bureaucrats will always have an incentive to ensure their own employment by over-providing these goods.
It is not clear whether the government should provide mail service (UPS or Federal Express may do so more efficiently), train service (US freight service has become much more efficient since privatization), telecommunications (British Telecom again has become much more efficient since privatization), health service (from the European National Health Services to the US Medicare) or insurance services such as Social Security. Nor is it clear that the government should NOT provide these services; they are likely to be hotly debated political issues for the foreseeable future.

MARKET FAILURE AND ITS CAUSES

MARKET FAILURE:

An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers. This is a direct result of a lack of certain economically ideal factors, which prevents equilibrium.

8 Major Causes of Market Failure (Explained With Diagram)

Some of the major causes of market failure are: 1. Incomplete markets, 2. Indivisibilities, 3. Common Property Resources, 4. Imperfect Markets, 5. Asymmetric Information, 6. Externalities, 7. Public Goods and  8. Public Bads.

Meaning:

In the real world, there is non-attainment of Pareto optimality due to a number of constraints in the working of perfect competition. An important cause of environmental degradation is market failure. It means poor functioning of markets for environmental goods and services. It reflects failure of government policy in removing market distortions created by price controls and subsidies.

1. Incomplete markets:

Markets for certain things are incomplete or missing under perfect competition. The absence of markets for such things as public goods and common property resources is a cause of market failure. There is no way to equate their social and private benefits and costs either in the present or in the future because their markets are incomplete or missing.

2. Indivisibilities:

The Paretian optimality is based on the assumption of complete divisibility of products and factors used in consumption and production. In reality, goods and factors are not infinitely divisible. Rather, they are indivisible. The problem of divisibility arises in the production of those goods and services that are used jointly by more than one person.

An important example is of road in a locality. It is used by a number of persons in the locality. But the problem is how to share the costs of repairs and maintenance of the road. In fact, very few persons will be interested in its maintenance. Thus marginal social costs and marginal social benefits will diverge from each other and Pareto optimality will not be achieved.

3. Common Property Resources:

Another cause of market failure is a common property resource. Common ownership when coupled with open access, would also lead to wasteful exploitation in which a user ignores the effects of his action on others. Open access to the commonly owned resources is a crucial ingredient of waste and inefficiency.

Its most common example is fish in a lake. Anyone can catch and eat it but no one has an exclusive property right over it. It means that a common property resource is non-excludable (anyone can use it) and non-rivalrous (no one has an exclusive right over it). The lake is a common property for all fishermen.

When a fisherman catches more fish, he reduces the catch of other fishermen. But he does count this as a cost, yet it is a cost to society. Because the lake is a common property resource where there is no mechanism to restrict entry and to catch fish. The fisherman who catches more fish imposes a negative externality on other fishermen so that the lake is overexploited.

This is called the tragedy of the commons which leads to the elimination of social gains due to the overuse of common property. Thus when property rights are common, indefinite or non-existent, social costs will be more than private costs and there will not be Pareto Optimality.

4. Imperfect Markets:

Pareto efficiency increases under perfect competition. But it declines under market distortions or imperfections. Let us consider a case of monopoly. Initially, monopoly equilibrium is at point E where the private marginal cost curve, PMC, cuts the marginal revenue curve, MR, from below.

The monopolist produces OQ1 output at OP1 price. But the production process generates smoke in the air. Therefore, the pollution board levies a tax equal to ТЕ on the monopoly firm. The imposition of a pollution tax is, in fact, a fixed cost to the monopoly firm. Now the social marginal cost curve cuts the marginal revenue curve at point e.

The monopolist increases the price of his product from OP1 to OP2and restricts output to OQ2 and thereby reduces consumers’ surplus to Q2 MLQ1 (= OQ1 LP1 – OQ2 MP2). In fact, Q2 MLQ1 is the social cost of OQ2 output. But the net loss to society is Q2 MLQ1 – TE= eMLT, the shaded area in the figure.

5. Asymmetric Information:

Pareto optimality assumes that producers and consumers have perfect information regarding market behaviour. But according to Joseph Stiglitz, “In the real world, there is asymmetric (incomplete) information due to ignorance and uncertainty on the part of buyers and sellers. Thus they are unable to equate social and private benefits and costs.”

Suppose a producer introduces a new antipollution device in the market. But it is very difficult for him to predict the current demand of his product. On the other hand, consumers may be ignorant about quality and utility of this anti-pollution device. In some cases, information about market behaviour in the future may be available but that may be insufficient or incomplete. Thus market asymmetries, fail to allocate efficiently.

6. Externalities:

The presence of externalities in consumption and production also lead to market failure. Externalities are market imperfections where the market offers no price for service or disservice. These externalities lead to malallocation of resources and cause consumption or production to fall short of Pareto optimality.

Externalities, lead to the divergence of social costs from private costs, and of social benefits from private benefits. When social and private costs and social and private benefits diverge, perfect competition will not achieve Pareto optimality.

Because under perfect competition private marginal cost (PMC) is equated to private marginal benefit (i.e. the price of the product). We discuss below how external economies and diseconomies of consumption and production affect adversely the allocation of resources and prevent the attainment of Pareto optimality.

Positive Externalities of Production:

According to Pigou, when some firm renders a benefit or cost of a service to other firms without appropriating to itself all the benefits or costs of his service, it is an external economy of production. External economies of production accrue to one or more firms in the form of reduced average costs as a result of the activities of another firm.

In other words, these economies accrue to other firms in the industry with the expansion of a firm. They may be the result of reduced input costs which lead to pecuniary external economies. Whenever external economies exist, social marginal benefit will exceed private marginal benefit and private marginal cost will exceed social marginal cost.

This is illustrated in Figure 18.2 where PMC is the private marginal cost curve or supply curve of firms. The demand curve D intersects the PMC curve at point E and determines the competitive market price OP and output OQ.

SMC is the social marginal cost curve which intersects the demand curve D at point E1 and determines the social optimum output level OQ1 at price OP1. Since for every unit of output between OQ and OQ1 social marginal cost (ОР1) is less than the competitive market price OP, its production involves a net social gain equal to QQ1.

Negative Externalities of Production:

When the production of a commodity or service by a firm affects adversely other firms in the industry, social marginal cost is higher than social marginal benefit. Suppose, a factory situated in a residential area emits smoke which affects adversely health and household articles of the residents.

In this case, the factory benefits at the expense of residents who have to incur extra expenses to keep themselves healthy and their households clean. These are social marginal costs because of harmful externalities which are higher than private marginal cost and also social marginal benefit.

This is illustrated in Fig. 18.3 where the PMC curve which intersects the D curve at point E and determines the competitive price OP and output OQ. But the socially optimum output is OQ1and price is OP1, as determined by the intersection of SMC and D curve at point E1.

Thus the firms are producing Q1 Q more than the social optimal output OQ1. In this case, for every unit between Q1 and Q, social marginal cost (SMC) is more than the competitive market price OP. Thus its production involves a social loss i.e.. OQ – OQ1 – QQ1.

Positive Externalities in Consumption:

Externalities in Consumption lead to non-attainment of Pareto optimality. External economies of consumption arise from non-market interdependences of the satisfactions enjoyed by different consumers. An increase in the consumption of a good or service which affects favourably the consumption patterns and desires of other consumers is an external economy of consumption.

When an individual installs a TV set, the satisfaction of his neighbours increases because they can watch TV programmes free at his place. Here social benefit is larger and social cost is lower than the private benefit and cost. But the TV owner is likely to use his TV set to a smaller extent than the interests of society require because of the inconvenience and nuisance caused by his neighbours to him.

Negative Externalities in Consumption:

Negative externalities in consumption arise when the consumption of a good or service by one consumer leads to reduced utility (dissatisfaction or loss of welfare) of other consumers. Negative externalities in consumption arise in the case of fashions and articles of conspicuous consumption which reduce their utility to some consumers. For example, smokers cause disutility to non-smokers, and noise nuisance from stereo systems to neighbours etc. Such diseconomies of consumption prevent the attainment of Pareto optimality.

Suppose there are two room-mates A and B. Individual A likes to smoke while individual В likes clean air. Further, B’s utility of consuming clean air is affected by individual A’s smoking. This is explained in terms of Figure 18.4 (A) & (B). Initially, individual A’s utility from smoking gives him 50 utilis at point A while individual B’s consumption of clean air gives him 80 utilis at point B. When there are no externalities in consumption, the tangent at point A and point В are parallel to each other.

If individual A smokes at his leisure then his utility increases to 60 utilis and he moves to point E. The effect of individual A’s smoking reduces the utility of clean air to individual В who moves from point В to point F on the same utility curve.

Individual A has moved on a higher utility curve from 50 to utility curve 60, but the non-smoker is on the same utility curve 80. Thus Pareto optimality is not attained because the utility of one consumer (smoker) A has increased whereas the utility level of the other consumer (non-smoker) В has been reduced.

7. Public Goods:

Another cause of market failure is the existence of public goods. A public good is one whose consumption or use by one individual does not reduce the amount available for others. An example of a public good is water which is available to one person and is also available to others without any additional cost. Its consumption is always joint and equal.

It is non-excludable if it can be consumed by anyone. It is non-rivalrous if no one has an exclusive rights over its consumption. Its benefits can be provided to an additional consumer at zero marginal cost. Thus public goods are both non-excludable and non- rivalrous. Moreover, environmental quality is generally considered as a public good and when it is valued at market price, it leads to market failure.

The Paretian condition for a public good is that its marginal social benefit (MSB) should equal its marginal social cost (MSC). But the characteristics of a public good are such that the economy will not reach a point of Pareto optimality in a perfectly competitive market. Public goods create externalities.

The externality starts when the marginal cost of consuming or producing an additional unit of a public good is zero but a price above zero is being charged. This violates the Paretian welfare maximization criterion of equating marginal social cost and marginal social benefit. This is because the benefits of a public good must be provided at a zero marginal social cost.

Suppose potable water is supplied by the municipal corporation. There are two individuals A and В who use it. Both consume the same quantity of water. But they differ in how much they are willing to pay for any given quantity.

This is illustrated in Figure 18.5. where Da and Db are the demand curves of two individuals A and В respectively. Therefore, demand prices are OPa and OPb corresponding to a given quantity OW of water. The curve ΣD is the vertical summation of Da and Dbcurves.

The Lindhal equilibrium for a public good exists where the sum of the individual prices equal marginal cost. Therefore,

OP = OPa + OPb = MCW

But each consumer is being charged a different price. This is a case of price discrimination because price OPa is greater than price OPb for the same quantity of water OW. Hence there is market failure.

8. Public Bads:

There are also public bads in which one person experiencing some disutility does not diminish the disutility of another, such as air and water pollution. Public goods and public bads cannot be handled by the institution of private property. K.E. Boulding has explained public bads with the following example: “If someone drives his car into my living room and pollutes it, I can sue him for damages. This is a private bad. But if someone congests the roads or pollutes the air, however, there is not much I can do about it as an individual. This is public bad.”

Market failure is a necessary but not a sufficient condition for intervention. To be truly worthwhile, a government intervention must outperform the market or improve its functions. Second, the benefits from such intervention must exceed the costs of planning, implementation, and enforcement, as well as any indirect and unintended costs of distortions introduced to other sectors of the economy by such intervention.

Public Finance:Incidence of Taxation: Meaning, Shifting the Burden of a Tax and other Details

Some of the main incidence of taxation are as follows: 

Meaning of Incidence:

It is important to study who ultimately bears the burden of a tax. The incidence of taxation refers to this question of who and in what proportion bears the final burden of a tax. It is not necessary that a person or a firm who pays a tax to the Government or, in other words, bears the initial burden of a tax will also be one on whom the final burden of the tax rests.

This is because a tax can be shifted or transferred to others. Therefore, in economics, we distinguish between the impact and incidence of a tax. Whereas the impact of a tax is said to be resting on the person or firm who pays the amount of the tax and thus receives the initial burden, the incidence of the tax tests on the person or firms who ultimately bears the money burden of the tax. If a person or a firm who pays the tax to the Government is also one who ultimately bears it, then the impact and incidence of the tax rests on the same person or firm. In such a case, there is no shift.

Shifting the Burden of a Tax:

The burden of the tax can be transferred to others through a process of shifting. It may be noted that the whole burden of the tax may not be shifted to others. It may be that a part of the tax may be shifted to others and a part be borne by the one who initially pays the tax.

As a matter of fact, a part of the tax burden rests on all the persons to a larger or smaller degree in the chain of transferring the burden so that at the ultimate end only a small burden rests. The process of shifting the burden of a tax goes on so long as different persons who come in the chain are able to pass on the burden to others till it ultimately rests on a person or a group of persons who cannot shift this unwelcome baby further.

Theory of incidence of tax studies in what proportion the burden or incidence of a tax is shared among different persons. It may be noted that a tax can be shifted through a process of exchange or, in other words, an individual or a firm can shift the burden of the tax if there occurs exchange relations which are conducted on the basis of prices of goods and factors.

The person who initially pays the tax can pass it on to the other either in the form of higher prices of goods he sells or in the form of lower prices of factors he buys. Whether shifting can take place or if it does so how much tax burden can be shifted depends on a number of factors.

They are briefly explained below:

1. The Nature of a Tax:

The nature of a tax as to whether it is a tax on the production or sale of some commodities or it is a personal income or property tax. Tax shifting can easily take place in the case of taxes on the production and sale of commodities. The taxes on pro­duction or sale of commodities are called indirect taxes. The important examples of indirect taxes are excise duties and sales tax. On the other hand, the burden of direct taxes such as income and wealth taxes cannot be shifted.

2. Market Conditions:

Whether commodity is being produced under conditions of perfect competition, monopolistic competition or monopoly goes to determine the extent to which the burden of the tax can be shifted. A monopolist who has a full control over the supply of a commodity is in a better position to shift the burden of a tax on the commodity produced.

Likewise, a producer working under monopolistic competition who produced a product somewhat different from others exercises a good deal of influence over the price of its product and therefore can pass on a part of the burden of the tax to the buyers.

Even the firms working under perfect competition can shift the tax burden as the tax levied on a commodity raises its supply price for all of them. The difference in the three market forms lies in the extent to which the burden of the tax can be shifted.

3. Physical Conditions of Production:

The shifting of the tax burden on a commodity also depends upon whether the commodity is being produced under increasing, constant or diminishing returns. This will be explained in detail a little later.

Factors Determining Incidence of Indirect (Commodity) Taxes:

The questions of tax shifting especially arise in the case of indirect taxes, that is, taxes on the production and sale of goods such as excise duties and sales tax. In this regard, whether and to what extent a tax on commodity can be shifted depends on the price elasticity of demand for and supply of a commodity.

It is these elasticity’s of demand and supply that determine the bargaining strengths of the sellers and buyers of the taxed commodity. Sellers can shift the tax burden to the buyers if they are able to re­duce the supply of the commodity and thereby raise its price.

Thus, the power to shift the tax depends on the elasticity of supply of the taxed commodity. The elas­ticity of reducing supply of a commodity will be relatively smaller if there is excess capacity in the industry producing it. Fur­ther, the elasticity of supply of a commod­ity will be larger in the long run than in the short run.

Apart from the elasticity of supply, power to transfer the tax burden depends on the-elasticity of demand for a commod­ity. The greater the elasticity of demand of the buyers, the smaller the extent to which the tax will be shifted to them.

As shall be shown below, under conditions of perfect competition the incidence of a commodity tax is shared between the sellers and buyers in the ratio of the elasticity of demand and supply. Figure 32.1. Illustrates the incidence of an indirect tax under conditions of perfect competition.DD is the demand curve for a commodity and SS is its supply curve before the imposition of tax on it. Interaction of these demand and supply curves determines price OP of the com­modity and OM is the quantity sold and purchased.

Suppose a unit sales tax, that is, sales tax per unit of the commodity equal to SS’ or LQ is levied by the Government on the commodity in question. This will raise the supply price of the commodity by the sellers as the unit tax SS’ will now be included by the sellers in their supply price.

As a result, the supply curve of the commodity will shift to the left by the magnitude of the tax SS’. The new supply curve S’S’ intersects the demand curve DD at the point Q and determines the new price OP’ and quantity exchanged OT.

It will be seen from Fig. 32.1 that price for the buyers have risen by PP’ or RQ whereas the tax per unit is SS’ or LQ which the buyers will bear. It may be noted that the buyers will bear the burden of a tax to the extent that they have to pay the higher price than before.

Thus the incidence of the tax borne by the buyers will be equal to RQ. The remaining part of the tax RL will be borne by the sellers. Thus, of the tax SS’ or LQ per unit, RQ is incidence of the tax on the buyers and RL is the incidence on the sellers. Now, we can show that the incidence of the tax RL and RQ on the sellers and buyers respectively is equal to the ratio of the elasticity of demand and the elasticity of supply.

RL/RQ = Incidence of tax on the sellers/ Incidence of tax on the buyers

Since RL is the incidence of the tax on the sellers and RQ is the incidence of tax on the buyers, we find that

RL/RQ = Incidence on sellers/ Incidence on buyers

= Price elasticity of demand/ Price elasticity of supply …(iii)

To conclude, to what extent the burden of the tax will be shifted and the proportion in which the buyers will share the incidence of a commodity tax depends on the elasticities of demand and supply.

What exactly incidence of tax on buyers RQ and incidence of tax on sellers RL will be equal to is given below:

ed/es = RL/RQ = Incidence of tax on sellers/ Incidence of tax on buyers …(iv)

If elasticity of demand for a commodity is zero, then from (iv) it follows that the incidence of tax on the sellers RL will be zero and from (iv) above it follows that incidence of tax RQ on buyers will be equal to whole tax t per unit. On the other hand, if the elasticity of supply is zero, then it follows from (iv) above that the incidence of tax on sellers RL will be equal to the whole amount of the tax t and as a result the incidence of tax 011 the buyers in this case will be zero in this case.

If elasticity of demand is infinity (ed. = ∞) then it also follows from above that RL = t, that is, the whole burden of the tax will fall on the sellers. On the other hand, if elasticity of supply is infinity, then it follows from above that RQ – t, that is, the whole burden of the tax will fall on the buyers. Let us graphically explain these cases of incidents of tax.

Incidence of Indirect Taxation and Elasticity of Demand:

If demand for a commodity on which a unit tax has been imposed is elastic, then as a result of the rise in price caused by the imposition of a tax, the people will buy substitute goods and the quantity demanded of the good will fall greatly.

In such a case, the incidence of the tax on the buyers will be relatively less. This is illustrated in Fig. 32.2. Take first, the demand curve DD which is relatively more elastic as compared with the demand curve D’D’ (dotted). SS is the supply curve which with the intersection of demand curve DD determines the price OP and quantity exchanged OM.

With the imposition of a unit tax, the supply curve shifts to the left and intersects the demand curve DD at point Q determining new price OP’ and the equilibrium amount ON. The dis­tance between the two supply curves meas­ures the tax per unit which is equal to LQ.

It will be seen from the figure that with the demand curve DD price has risen by PP’ or RQ. The remaining tax LR will be borne by the sellers. It will be seen that in this case of elastic demand the incidence of the tax RQ fallen on the buyers is smaller than that on the sellers RL.Now take the case of less elastic demand curve D’D’ (dotted). It will be seen from the Fig. 32.2 that the supply curve S’S’ obtained after the imposition of the tax per unit inter­sects the less demand curve D’D’ at point J. In this case of less elastic demand curve, price has risen by a greater magnitude PP” or KJ which will be the incidence on the buyers, whereas the sellers will receive HK less than before the imposition of tax. It will be thus noticed that in this case of less elastic demand curve, the incidence of the tax on the buyers (KJ) is much greater than the incidence on the sellers (HK).

It follows from above, the less the elasticity of demand, the greater the incidence of tax on the buyers, and in the extreme case when the elasticity of demand is zero, the whole tax will be passed on to buyers. On the other extreme, when demand for a commodity is perfectly elastic, the whole tax will be borne by the sellers of the commodity.These are illustrated in Figs. 32.3 and 32.4. Take Fig. 32.3 which illustrates the case where demand curve is completely inelastic (i.e., ed = 0) as actually happens in the case of necessities which cannot be substituted by some other goods and therefore their demand for them do not decline following the rise in the price after the imposition of a tax on them. It will be observed from Fig. 32.3 that in this case of completely inelastic demand price rises by the full amount of the tax when tax on the commodity is levied resulting in shift in the supply curve from SS to S’S’. Thus, in case of perfectly inelastic demand the whole incidence of tax rests on the buyers.Figure 32.4 illustrates the other extreme case of perfectly elastic demand curve for a com­modity. In this case price for the buyers remains the same following the imposition of tax and shifting of the supply curve from SS to S’S’. Thus in this case of perfectly elastic demand, tax burden on the buyers will be nil. As will be seen from Fig. 32.4, the quantity demanded falls from OM to ON and the price received by the sellers falls by the full amount of the tax QL. Thus, in case of perfectly elastic demand, the whole burden of the tax rests on the sellers.

Elasticity of Supply and Incidence of a Tax:

The division of the tax burden between the buyers and sellers also depends on the elasticity of supply. Given the demand conditions, the greater the elasticity of supply, the greater the incidence of tax resting on the buyers (consumers) of a commodity. Figure 32.5 represents the case of a commodity with a relatively elastic supply.When the tax is levied on this commodity and supply curve shifts from SS to S’S’, the price rises from OP to OP’. The price increase is equal to PP” or RQ which will be the incidence of the tax on the buyers. Price received by the sellers is lower by RL and this will be the burden of the taxation on the sellers. It will be noticed that in this case of elastic supply curve, the incidence of tax on the buyers is greater than that on the sellers.Figure 32.6 shows the incidence of tax in case of commodity with a perfectly elastic supply. It will be seen from this that as a result of the imposition of tax on this commodity and shifting of the supply curve, price rises by the full amount of the tax. Thus, in case of perfectly elastic supply the buyers have to bear the whole burden of the tax.Figure 32.7 represents the incidence of tax in case of commodity with a relatively inelastic supply. It will be observed that the incidence of a tax on this commodity will be less on the buyers (RQ) than on the sellers (RL).Incidence of an Indirect Tax and Cost Conditions of the Industry:

As mentioned above, cost conditions of the industry also determine the incidence of tax on buyers and sellers.

From the viewpoint of cost, industries can be divided into three categories:

(1) Increasing Cost Industries,

(2) Constant Cost Industry,

(3) Decreasing Cost Industry.

Following the imposition of a tax on a commodity, its price rises and, given the demand curve, at a higher equilibrium price less is demanded and produced. If a commodity is being produced under increasing cost conditions, then at a lower level of output cost per unit of output will fall. And due to this reduction in cost per unit as a result of imposition of a tax on that commodity, the price of the commodity will rise by less than the amount of the unit tax levied.Thus, in this case which is illustrated in Fig. 32.8 the burden of the tax on the buyers will be less than the amount of the unit tax. On the contrary, when a commodity is being produced by an industry subject to decreasing costs, the decline in demand and output as a result of the imposition of a unit tax and rise in its price will cause cost per unit to rise.

In this case, as shall be seen from the Fig. 32.9, the price will rise more than unit tax on account of (1) imposition of tax on the commodity, and (2) rise in unit cost at a lower level of output. It will be observed from Fig. 32.9, while tax imposed on the commodity equals RQ, the price has risen by LQ or PP’ which is greater than RQ.When the production of a commodity in an industry is subject to constant costs, then decline in output following the imposition of a unit tax and rise in price does not cause change in unit cost of production. In this case, as shall be seen from the Fig. 32.10 the price of a commodity rises by the same amount as the unit tax levied on it. Therefore, the whole burden of the tax will rest on the buyers.

Conclusion:

From our above analysis of the impact of cost conditions or physical returns to scale on the incidence of a commodity tax on the buyers and sellers we arrive at the following conclusions:

1. The incidence of a unit tax on the buyers will be less than the amount of the tax when the commodity is being produced under increasing cost conditions.

2. The incidence of tax on the buyers will be greater than the tax when the commodity is being produced under decreasing cost conditions.

3. The incidence of tax on the buyers will be equal to the amount of the tax when the production of the commodity is subject to constant costs.

MA EXTERNAL KARACHI UNIVERSITY: DATE SHEET FOR 2014 EXAMS