Back to the tax

It’s time to pull our knowledge of economic surplus together and realise the point of our previous articles. We've seen how taxes reduce surpluses and how the loss is shared between consumers and producers. But how this loss is shared depends largely on the type of product being taxed. Some goods are extremely important to us, and even if prices rise we tend to keep purchasing them. What would this demand curve look like?

Figure A shows the relationship between the price consumers must pay for an important good (lets just call the good e for now ;- ) and the quantity of it they buy. The main take away is that even if ‘e’ almost doubles in price from $5.00 to $9.00, consumers still purchase one ‘e’. The mathematically inclined will notice that an 80% increase in price only results in a 67% fall in the quantity purchased, but the intuitive qualitative understanding of what is going on is more important. Lets compare this to a less important good.

What about when we go out shopping for 'Alpaca Woven Foot Loofahs'? Do we act the same way? I'm gonna go out on a limb and say that an Alpaca Woven Foot Loofah is a luxury, and as the price goes up we quickly stop purchasing them in favour of cheaper alternatives. If the touch of treated alpaca fur on your skin is a daily staple you couldn't do without no matter what the price, well humour me and read on. Figure B shows a demand curve where the relatively meagre $1.00 increase results in a drop in the amount of Alpaca Woven Foot Loofahs being bought by 18. A 20% increase in price results in a 90% fall in loofah purchases.

Now what’s the first kind of good we think of when we think carbon tax: electricity! Which is a pretty good example of a product we can't go without. It is said to have low price elasticity of demand, because for a given change in price, demand will change very little, like in Figure A. So what happens when a tax is put in place?

Before we see that, lets first have a look at high elasticity markets and tax. Figure C shows your average Alpaca Woven Foot Loofah market, where ten loofahs are bought for $5.00. Note the elastic (ie flat) demand curve. Remember from How Labor’s new budget is going to reduce our surplus that the area above the price and below the demand curve is consumer surplus, shaded in red here. Because the supply curve represents how much it is costing producers to put together the next loofah, producer surplus is the area above the supply curve and below the price they are receiving, shaded in yellow.

Just as we did with cars, we are now going to throw in a tax. Enter Figure D. For every Loofah that trades the government will take sixty cents, and after buyers and sellers haggle with one another in the marketplace, they finally decide upon a price and quantity that suits both parties (producers and sellers that is). Unfortunately for the tender feet of several participants, the economy enjoys three less loofahs. However if you look closely, you’ll notice that consumers took a relatively small hit (that hit being represented by the purple slice).

Now sure consumers enjoy less loofahs, and those that still purchase loofahs must pay a higher price, but comparing consumers' surplus before the tax to consumers’ surplus after the tax (red shade) there isn't a great deal of difference. Producers’ surplus on the other hand (yellow shade) took a beating. Selling less loofahs at a much lower price has resulted in a relatively large chunk of producer surplus disappearing (the dirty brown colour underneath the purple). Of course the ever present winners take the tax, represented by the blue colour, which while equalling a loss to the private sector, is spent efficiently and equitably by government on public goods, so is not supposedly a loss to society.

Figure E is where it starts to get relevant. Our electricity demand curve slopes downward steeply, representing our inability to switch to substitute products when price rises. As before the red is consumer surplus and the yellow is producer surplus.

Throw down a $6.00 tax per good and you've got Figure F. This time you can see that the loss of consumer surplus (purple area) is much greater than the loss of producer surplus  When producers sell a product that people can’t do without, the burden of the tax is borne predominantly by consumers.

This is the complicated economic way of saying that if we really need a good, companies can raise the price of it without fear of people substituting the good for something else (or just going without). When companies costs rise due to the tax, the tax will be passed onto consumers. I began the previous article noting that politicians have been running their mouths about not letting companies raise prices too high (whatever that exactly means, but that’s an article for another day) due to the carbon tax. The reason I have taken you through the painful process of mapping it out graphically is to really show that companies raising prices and stickin' it to the consumer IS THE ECONOMICALLY EFFICIENT OUTCOME, AS PREDICTED BY MAINSTREAM THEORY TO BE THE NATURAL AND REQUIRED ORDER. There is no politically engineered spin that can turn this into roses. Just as nature intended electrons to gravitate towards one end of a water molecule, the tax is supposed to raise prices and it is supposed to be borne by consumers (us economists love to pretend we’re physicists). This string of articles makes no points for or against a carbon tax, but I hope it cuts through the spin, and shows what all those who are enlightened (including political economic advisers) already know.

Producer surplus

Consumer surplus

Carbon tax

Price increases