Updated: Jan 8, 2021
We will be solving practical challenges through MBA concepts. No theory only applications !
This article is a leaf from managerial economics taught in bschools and is an extension from my previous article on "lesson 8: when does government regulate ?"
It involves one form of government intervention called "taxes" and explain with a particular scenario why its needed apart from reasons usually discussed in public- revenue source for government. We also cover the unfortunate yet unavoidable downsides of the taxes at a very big picture level. While many consider such topics to be non actionable, the primary reasons they are taught in bschools is to ensure we are well informed business professionals !
With that let's start the drill !
Step 1: Problem
So, we have a market failure (refer lesson 8) in case of high cigarette consumption in a particular economy and Government realizes it's time to intervene in the market. The Government leverages it's one of the most used intervention tool- Taxes
Step 2: Action
Scenario 1: No tax
Demand : P (Price)= 50-2Q; Supply : P (Price)= 10+3Q (derived from demand supply curve)
You solve and get quantity demanded and price sold as=> Q=8 and P=34
Scenario 2: Gvt imposes $5 on sellers
Demand : Price= 50-2Q; Supply : P-5= 10+3Q
Q=7 and P= 36 (the price increased and obviously quantity demanded decreased-> intended goal)
Step 3: Dead weight loss
Graph on the left shows the efficient market where the price clears at the equilibrium (intersection point of both demand and supply).
The blue triangle represents consumer surplus- the "extra" value consumer derives after paying price P* because the highest value in terms of price associated with the product is when Q=0 on demand line but consumer only pays p*.
The green triangle represent producer surplus in terms of the revenue made on production.
Now comes the interesting part (refer left graph). The Government intervenes in and changes price of the commodity through tax. The Gvt. takes a share from both consumer and producer surplus by changing price and decreasing quantity demanded.
However, in this process there is a dead weight loss (small traingle near intersection). The loss is net value loss of the society: loss of producer, loss of consumer and the government doesn't gain revenue either.
Now, I am not propagating that taxes shouldn't be levied because of dead weight loss. The take away is it's imperative to know the down sides in terms of pure economics- here it is dead weight loss !
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