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Economics / Economic Theory
August 30, 2010 – 11:14 am GMT

By: Andy_Sutton


Economy

Best Financial Market Analysis ArticlePartial equilibrium (PE) analysis is one of the many tools available to economists and analysts to determine the appropriateness of fiscal or economic policy. However, many scoff at the idea of ​​using partial equilibrium simply because many of its assumptions are deemed too unrealistic. However, to examine the potential benefits (or costs) of a policy such as a single asset tax, PE is a very valid construct. One of the hottest topics these days in almost every state is how to increase revenue (rather than cut costs). One of the states’ traditional cash cows comes in the form of gasoline taxes. The same is true of the federal government in this regard. However, as we all know, simply arbitrarily and capriciously taxing a product is not necessarily effective. In fact, this is usually not the case.

Supporters of additional gasoline taxes have pointed out that the additional revenue gives the tax authority resources it can use for the benefit of citizens, increase spending and generate economic activity. This argument centers on the belief that the government can allocate economic resources in the most efficient way. Opponents claim that taxes create an unnecessary and unfair drag on economic agents (people) who tend to create the most obstacles to economic activity. Their argument is based on the belief that economic agents can allocate resources more efficiently than government.

The objective of this exercise is to assess the effectiveness of this instinctive and unavoidable tax mechanism, and also to examine the fairness of these taxes. It should be noted before starting that gasoline is not a true final good since it is used in some cases in the production or supply of other final goods and / or services.

Scope of the PE analysis and assumptions

Typically, PE scan works much better for more specific instances. For example, our exercise of a tax on a single product (one gallon of gasoline) lends itself much better to the EP than the government’s proposal to add VAT to all products. In the case of VAT, the general equilibrium analysis would be more appropriate.

The following assumptions are used in the PE analysis:

  • The market under surveillance is that of a private good. There are no externalities such as imports and / or exports.
  • All product and factor markets are perfectly competitive.
  • There is no government intervention

These assumptions mean that we can consider the gasoline demand curve as equal to marginal social benefit (MSB) and the supply curve as equal to marginal social cost (MSC). By aggregating the individual curves of all economic agents, we can derive the total demand and total supply curves (shown below).

From this, we can derive the Total Social Benefit (TSB) and Total Social Cost (TSC) for a market by summing the marginal benefits and costs for all units purchased / produced according to the following:

TSB = ∑MSB (1toBought)
TSC = ∑MSC (1àQproduct)

Before anyone gets too excited about government intervention and externalities assumptions, these can either be removed from the analysis or mitigated once a benchmark has been established.

Interpretation and Pareto efficiency

For now, it is important to relate the supply and demand of a product to the concept of net social benefit / cost. Really, when you think about it, the validity of any tax or subsidy is whether its benefits outweigh its costs. If we can answer “yes” to this question, then from a strictly economic point of view, it is a valid policy.

One of the measuring sticks used to interpret the results of PE analysis is the concept of Pareto efficiency, which simply states that efficiency exists when all the factors are such that a part cannot be improved without aggravate another part. In other words, our gasoline tax would be Pareto efficient if it were structured so that its net benefits to government and individuals equal or exceed its net costs to other individuals.

It is crucial to note that just because something makes economic sense and is Pareto efficient does NOT mean that it is fair. There are many instances of taxes and levies that can meet Pareto’s criteria for efficiency, but you’ll have a hard time convincing taxpayers that it’s fair.

Supply, demand and total net social benefits

With the previous assumptions in place, it is now possible to examine the demand function for a particular product, in this case gasoline, and interpret it as a social benefit. This is important because one of the goals of PE analysis is to create a cost-benefit scenario and then make judgments from there. Having said that, if we know the demand function of each individual, it is straightforward to derive the total demand for that particular good, or in our case, the total social benefit. We can aggregate the supply curves in the same way and deduce the total social cost. Once we have these two elements, the search for a net social benefit is done by:

TNSB = TSB – TSC

Where TNSB is the total net social benefit, TSB is the total social benefit and TSC is the total social cost.

Below we take a look at a chart with three quantity levels, Q0, Q1, and Q2. Using PE, we will then analyze the TNSB at each point.

In traditional general equilibrium analysis, Q1 represents what we would think of as the equilibrium at P1 (unlabeled). However, using PE, we will be looking at the TNSB at each level of Q.

Let’s look at Q0. The area under the demand curve (MSB) is A + B. This represents the TSB for gasoline. The area under the supply curve (MSC) is B. Subtracting TSC from TSB gives us a TNSB of A. Following the methodology of Q1, we get a TNSB of A + C, which is obviously more optimal than that of Q0. In this case, the highest TNSB occurs at market equilibrium Q1.

Another look at market efficiency

For the sake of comparison, let’s take another example and take a look at the different surpluses that occur and what that means for balance:

It is also relatively easy to see how we can look at the surpluses generated at the different levels of Q and attribute those surpluses to producers or consumers. Looking at the market equilibrium graph above, we can see that the consumer surplus in this case is the value of consumer purchases (total profits) minus the cost paid. Consumers received the value of ABC and paid BC, leaving the consumer’s surplus of A. The producer surplus equals the total payments received (B + C) minus the opportunity cost of producing the goods (C ), leaving the producer surplus to B. The TNSB of this situation is the sum of the producer and consumer surplus (A + B). It is important to note that:

  • Market equilibrium requires MSB = MSC,
  • Supply equals demand, and
  • Assuming that there are no externalities, the market equilibrium represents a Pareto optimum (as illustrated above).

In the next article, we’ll apply the concept of PE analysis to the notion of an additional tax on every gallon of gasoline sold and determine if, in fact, that would represent market efficiency.

References: Primer on PE: R. Wigle, Microeconomics: J. Perloff.

By Andy Sutton
http://www.my2centsonline.com

Andy Sutton holds an MBA with Honors in Economics from Moravian College and is a Fellow of the Omicron Delta Epsilon International Honor Society in Economics. His firm, Sutton & Associates, LLC is currently providing financial planning services to a growing number of clients using a conservative approach aimed at accumulating high-quality, income-producing assets while providing protection against the falling dollar. For more information visit www.suttonfinance.net

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