ECON1210

Tutorial 6 – Taxes and

Subsidies
Teaching assistant: Louise LIU
 Roadmap

1. Key concept recall • Introduction to Tax/Subsidy

• Tax burden/ Share of subsidy benefit
• Deadweight loss

2. Example questions 5 example questions, 8 past paper exam questions

3. Attendance exercises
 Key concept recall: introduction to tax /subsidy
When a $3 per unit tax is impsed on buyers… When a $3 per unit tax is impsed on sellers…
Ps=5+0.01Q
Ps=5+0.01Q Pd=20-0.02Q
Pd=20-0.02Q Ps(new)=5+0.01Q+3
Pd(new)=20-0.02Q-3

PD PD

PS PS

Price paid by buyers: PD =12

Price received by sellers: PS =9
PD - PS =t (wedge approach)
 Key concept recall: introduction to tax /subsidy
When a $3 per unit subsidy is provided for buyers… When a $3 per unit subsidy is provided for sellers…
Ps=5+0.01Q Ps=5+0.01Q
Pd=20-0.02Q Pd=20-0.02Q
Pd(new)=20-0.02Q+3 Ps(new)=5+0.01Q-3

Price paid by buyers: PD =8

Price received by sellers: PS =11
Ps - PD =s (wedge approach)
 Key concept recall: tax/subsidy

Remarks 1. Who pays (receives) more of the tax (subsidy) depend on the relative
elasticities of demand and supply.
• The more inelastic side will pay (receive) a larger share of a tax (subsidy)

- similar analysis applies to the case with a subsidy

 Key concept recall: tax/subsidy
Remarks 2. Taxation and subsidization shall normally create lost gains from trade (i.e. deadweight
loss) except under some extreme cases (perfectly inelastic demand/supply).
• Relationship between ΔCS, ΔPS, deadweight loss and tax revenue/subsidy expenditure
• Deadweight loss would be greater with more elastic demand/supply
 Key concept recall: extreme cases (zero deadweight loss)
In the case of taxation…

- similar analysis applies to the case with a subsidy

Key concept recall: Relationship between ΔCS, ΔPS, deadweight loss and tax revenue

Tax revenue

Deadweight loss

Pd

Ps

ΔCS+ΔPS=tax revenue + deadweight loss

Key concept recall: Relationship between ΔCS, ΔPS, deadweight loss and tax revenue

Change in CS Tax revenue

Deadweight loss

Pd

Ps

ΔCS+ΔPS=tax revenue + deadweight loss

Key concept recall: Relationship between ΔCS, ΔPS, deadweight loss and tax revenue

Tax revenue

Deadweight loss

Pd

Ps

ΔCS+ΔPS=tax revenue + deadweight loss

Key concept recall: Relationship between ΔCS, ΔPS, deadweight loss and tax revenue

Change in CS Tax revenue

Change in PS
Deadweight loss

Pd

Ps

ΔCS+ΔPS=tax revenue + deadweight loss

Key concept recall: Relationship between ΔCS, ΔPS, deadweight loss and subsidy
expenditure

Subsidy expenditure

ΔCS+ΔPS + deadweight loss = subsidy expenditure

Key concept recall: Relationship between ΔCS, ΔPS, deadweight loss and subsidy
expenditure

Subsidy expenditure

Change in PS

ΔCS+ΔPS + deadweight loss = subsidy expenditure

Key concept recall: Relationship between ΔCS, ΔPS, deadweight loss and subsidy
expenditure

Subsidy expenditure

ΔCS+ΔPS + deadweight loss = subsidy expenditure

Key concept recall: Relationship between ΔCS, ΔPS, deadweight loss and subsidy
expenditure

Change in CS Subsidy expenditure

Change in PS

ΔCS+ΔPS + deadweight loss = subsidy expenditure

Key concept recall: Relationship between ΔCS, ΔPS, deadweight loss and subsidy
expenditure

Change in CS Subsidy expenditure

Change in PS

Deadweight loss

ΔCS+ΔPS + deadweight loss = subsidy expenditure

 Key concept recall: tax & subsidy-Illustration of Remarks #2(2)

Deadweight loss would be greater with more elastic demand/supply

Example question 1
 Example question 1
Solution
Without subsidy: Equilibrium quantity = 60, Equilibrium price = 6.
Increase the quantity traded by 20 → New quantity traded = 80
Subsidy wedge approach: Subsidy = Ps – Pd = 8 − 4 = 4
Example question 2
Example question 2
ΔCS+ΔPS=tax revenue + deadweight loss
Example question 3-5
The government decides to impose a $2 tax for every unit of bio-fuel. The demand and supply curves of bio-fuel are Qd =
16 − 2P and Qs = 3P – 4 respectively.

3. The quantity traded would be lowered to [Answer 4A] and the taxation creates a loss in total economic surplus of
[Answer 4B] dollars.

4. As a result of the tax, buyers will pay [Answer 5A] dollars more and sellers will receive [Answer 5B] dollars less.

5. It tells that the supply [Answer 6].

A. is relatively elastic than the demand
B. is relatively inelastic than the demand
C. has the same elasticity as the demand
 Example question 3-5
Solution Q3
Qd=Qs →16-2P=3P-4
Without tax: Equilibrium quantity Q* = 8, Equilibrium price P* = 4

With the imposition of tax, tax wedge approach: Pd – Ps = 2 or Ps = Pd – 2.

At the after-tax equilibrium, quantity supplied should be equal to quantity demanded.

16-2Pd=3Ps-4
16 – 2Pd = 3(Pd–2) – 4
Pd = 5.2
Hence, Ps = 3.2, Qd = Qs = 5.6

DWL = (tax × change in quantity)/2 = [2×(8–5.6)]/2 = 2.4

Example question 3-5

Solution Q4
• Buyers will pay (5.2 – 4) = 1.2 dollars more
• Sellers will receive (4 – 3.2) = 0.8 dollars less

Solution Q5
Since the more inelastic side will bear a larger tax burden, this implies that the
demand is more inelastic than the supply (1.2 > 0.8).

A. Supply is relatively elastic than the demand

Past Exam Question 2023 Spring Final Q16
 Past Exam Question 2023 Spring Final Q16
Solution
Key point: The mid-point of a linear downward-sloping demand is revenue-maximizing!

Mid-point of original demand = (368, 14.9)

• x-intercept = 368 × 2 = 736 (point A), y-intercept = 14.9 × 2 = 29.8 (point B)
→m=(29.8-0)/(0-736)=-0.04049, c=y-intercept=29.8 → Pd=-0.04049Q+29.8

New demand: Shift original demand upwards by the amount of unit subsidy 5.8 dollars
• Pd= -0.04049Q+29.8+5.8= -0.04049Q + 35.6 → y-intercept: 35.6, x-intercept=35.6/0.04049=879.25
Revenue-maximizing price = 35.6/2 = 17.8
Revenue-maximizing quantity = 879.25/2 = 439.62
Past Exam Question 2022 Spring Midterm Q41-42
Past Exam Question 2022 Spring Midterm Q41-42
SolutionQ41
Qd=Qs → 50000-250P=1000P-20000
Without tax: Equilibrium quantity Q* = 36000, Equilibrium price P* = 56
At new Q = 36000 – 4800 = 31200:
• Pd = (50000-31200)/250 = 75.2
• Ps = (31200+20000)/1000 = 51.2

With the imposition of tax, tax wedge approach:

t = Pd – Ps
t = 75.2 – 51.2
t = 24
Past Exam Question 2022 Spring Midterm Q41-42

Solution
Q42
Note that t = Pd – Ps = (50000-Q)/250 – (20000+Q)/1000 = 180 – Q/200
P
Consider ½ × ∆Q × tax = DWL
S
½ × (36000 – Q) × (180 – Q/200) = 85000 pd

--> (1/200)*Q2-360Q+6310000=0

Solve the quadratic equation using quadratic formula: Ps

1
𝑏2−4𝑎𝑐 −(−360)± 360 −4∗ 200 ∗6310000
2
−b±
→ desired Q = 2𝑎
= 1
D
2∗( )
200

→ Q1=41830.95 (deleted, quantity under taxation cannot increase), Q2=30169.05 Q Q

Maximum tax = 180 – 30169.05/200 = 29.15

 Remark
Past Exam Question 2022 Spring Midterm Q41-42

Add What is the amount of unit tax such that government’s tax revenue is maximized?

There are several methods to optimize (i.e. maximize or minimize) an objective function:

1. Axis of symmetry

• For quadratic functions in the form of y = ax2 + bx + c, the maximized/ minimized point occurs at x = -b/2a

2. Method of completing the square

• Express in the vertex form of the quadratic function and find the corresponding “x”

3. Differentiation (knowledge in calculus is not required in this course)

𝜕f
• Apply the first order condition = 0 and find the corresponding “x”
𝜕𝑥
 Remark
Past Exam Question 2022 Spring Midterm Q41-42
Add What is the amount of unit tax such that government’s tax revenue is maximized?
• 2022 Fall Midterm Q39-40 and 2023 Spring Midterm Q39-41 are standard examples.
Denote the government’s tax revenue by R(t).
Then R(t) = t × Q = t × (36000 – 200t) = -200t2 + 36000t
From previous slide:
t = Pd – Ps = 180 – Q/200
Techniques of unconstrained optimization Therefore: Q=36000-200t

Mtd 1 attained at t = -36000/[2(-200)] = 90

Mtd 2 Vertex form: R(t) = -2a/b=-200(t-90)2 + 1620000
→ attained at t = 90
𝑑𝑅
Mtd 3 = −400𝑡 + 36000
𝑑𝑡

By FOC, we have t = 36000/400 = 90

 Remark
Past Exam Question 2022 Spring Midterm Q41-42 (slide 22)
Note
Students are required to know how to solve quadratic equations when there are questions on
setting DWL target, tax revenue target, and subsidy expenditure target.

• DWL target: 2020 Spring Midterm Q30-31 and 2022 Spring Midterm Q41-42 are standard
examples.
• Tax revenue target: 2022 Fall Midterm Q39-40 is a standard example.
• Subsidy expenditure target: 2021 Spring Midterm Q36-37, 2021 Summer Midterm Q45-46
and 2023 Summer Midterm Q40-41 are standard examples.
Past Exam Question 2020 Fall Midterm Q37-41
 Past Exam Question 2020 Fall Midterm Q37-41

Solution

Q37
∆𝑄 𝑃
Consider Ed = ×
∆𝑃 𝑄

-0.6 = (1/-1) × (50/Q)

Q = 250/3 ≈ 83.33

Q38
Let Demand: P = a – Q and Supply: P = b + Q
Put P = 50 and Q = 250/3 into the demand and supply functions, we have
a = 400/3 and b = -100/3
Hence, Demand: P = 400/3 – Q and Supply: P = -100/3 + Q
 Past Exam Question 2020 Fall Midterm Q37-41
Solution

For illustration purpose, assume that the subsidy is distributed to

consumers
Q38 (cont.) Q39
Ps-Pd=s=4.8
ΔQ=85.7333-83.33=2.4
(-100/3 + Q)-(400/3 – Q)=4.8 Quantity increase by 2.4 units
Q=85.7333
• Price paid by buyers = 400/3-85.7333=47.6
• Price received by sellers = -100/3+85.7333=52.4
Past Exam Question 2020 Fall Midterm Q37-41

Q40

Combined increased in CS and PS

=subsidy expenditure-DWL
=s*Qnew-0.5* ΔQ* s
=4.8*85.7333-0.5*2.4*4.8
=405.76
Past Exam Question 2020 Fall Midterm Q37-41
Solution Q41

Total economic surplus increases with smaller unit subsidy

• DWL decreases → Change in DWL

Under subsidy of 4.8:

DWL= ΔQ*s/2=2.4*4.8/2=5.76
Under subsidy of 2.4:

Ps-Pd=(-100/3 + Q)-(400/3 – Q)=2.4 →Q=84.533

ΔQ=84.533-83.333=1.2
DWL= ΔQ*s/2=1.2*2.4/2=1.44

• Change in DWL = 1.44-5.76=-4.32

Thank you!
(deadline for regular quiz 6:
25th October)