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On prices and taxes.

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budmad posted on Tue, Feb 23 2010 7:54 PM

I have a question about prices and taxes.

Let's say that government cuts taxes by 10%, then people believe that prices should fall by 10%, same thing might happen with rising costs, if costs rise by X% there should be a X% increasement  (approximately) in price.

I can't figure out if this really happens because, if prices are determined by supply and demand, and those willing to pay (or not) according to their subjective valorations, then prices should not be moving if a there's a change in taxes or costs because they are not fixed to those factors, but to subjective valorations and supply and demand

Am I right?

Then, why people say that if taxes are being raised, goods will be more expensive, or the same with costs. If they are, people will stop buying, o price was too low before.

Are the effects more related to those who are at the margin, meaning this those who won't buy that product if price is increased, and generally this are the poorer? What effect will bring this decrease in demand, but raise in price to business profits?

 

thanks!

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budmad:

I have a question about prices and taxes.

Let's say that government cuts taxes by 10%, then people believe that prices should fall by 10%, same thing might happen with rising costs, if costs rise by X% there should be a X% increasement  (approximately) in price.

I can't figure out if this really happens because, if prices are determined by supply and demand, and those willing to pay (or not) according to their subjective valorations, then prices should not be moving if a there's a change in taxes or costs because they are not fixed to those factors, but to subjective valorations and supply and demand

Am I right?

Yes. For example, if the government were to cut only taxes which were being sent out as foreign aid, prices domestically would actually rise since individuals now have additional money to spend but there is only the same amount of goods and services in the economy that were there before.

Then, why people say that if taxes are being raised, goods will be more expensive, or the same with costs. If they are, people will stop buying, o price was too low before.

Are the effects more related to those who are at the margin, meaning this those who won't buy that product if price is increased, and generally this are the poorer? What effect will bring this decrease in demand, but raise in price to business profits?

 

thanks!

Well, the general effect of government spending is subsidization of one sector at the expense of other sectors. "At the expense" means increased prices in the unsubsidized sectors to pay for the subsidized sectors. So, cutting taxes will usually cause prices to rise in the subsidized sectors whose subsidies have been cut and fall in all other sectors.

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budmad:

I have a question about prices and taxes.

Let's say that government cuts taxes by 10%, then people believe that prices should fall by 10%, same thing might happen with rising costs, if costs rise by X% there should be a X% increasement  (approximately) in price.

I can't figure out if this really happens because, if prices are determined by supply and demand, and those willing to pay (or not) according to their subjective valorations, then prices should not be moving if a there's a change in taxes or costs because they are not fixed to those factors, but to subjective valorations and supply and demand

Am I right?

First, the change in price that results from a change in costs will depend on the relative elasticities of supply and demand. A 10% tax cut will only lead to a 10% fall in prices if we are dealing with a competitve market where demand is totally ineasltic. 

http://en.wikipedia.org/wiki/Tax_incidence

As for the second part of your question, you say that price is determined by subjective valuations and should not be impacted by changes in costs. I  think this is a situation where if you say "subjective" too many times your eyes go cross. Stick out tongue Rothbard notes in Chapter 4 of MES that sellers trade away their products for money because they value the things they can purchase with that money more than the product they are selling. That is the subjective part. But that doesn't mean they don't care about costs. If it costs them more to produce that product, then they will have less money left over after the sale to buy what ever they want. So why would the same amount of product at the same price if they getting less value from the transaction? Instead, in order to get them to produce as much as they were producing before costs went up, buyers will have to pay sellers a higher price per unit. Make sense?

It might be easier to think about it from another direction that may be more familiar. Assume you are making $100 per hour at your job working 40 hours a week, when all of a sudden the government slaps a 90% income tax on you. Now you're only taking $10 per hour. You income has fallen by 3600 per week. Do you think you would still work as much or as hard as you did before the tax? If an employer wanted to make you work as much or as hard as you did before, wouldn't they have to pay you more to do so? 

Hopefully this clears things up.

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So, if taxes are being raised, then I will raise the price of what I produce, or I will stop producing that product.

 

Thanks to both for your replies.

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budmad:
I can't figure out if this really happens because, if prices are determined by supply and demand,

Prices are not determined by supply and demand. Wether a sale takes place or not is determined by price.

Take a really simple case. There are 100 people who want a sandwhich. All 100 are willing to pay a dollar for a sandwhich, 99 are willing to even pay 2 dollars, 98 to even pay 3 dollars, and so on till one gu yis even willing topay 100 dolaars for a sandwhich, cause he is really rich and really hungry. 

All that information about how many people are willing to pay how much is called "the supply curve", because graphs on graph paper in economics books are called curves.

Whay is it that only one person is willing to pay 100 bucks for a sandwhich, and all 100 are willing to pay a dollar? That is because of personal valuation, Each of those hundred individuals has his own unique combination of wealth, hunger, other expenses, psychological and other neds, that go into deciding for him how much he is willing to pay. But whatever his final decision is, if the price goes past that limit he is willing to pay, he just won't buy the sandwhich.

So if prices go up, less people are around who valuate the sandwhich at that higher price, and so less people will buy it.

and those willing to pay (or not) according to their subjective valorations,

"Subjective valuation" does not mean "Do I want a sandwhich at any price?" It means "What is the highest price am I willing to pay for a sandwhich today?"

then prices should not be moving if a there's a change in taxes or costs

Prices are made buy the sandwhich maker, who tries to find a price that will give him the maximum profit. He knows if he sells for cheap, he will sell more sanwhiches, but will make less profit on each one. If he sells for more, he will sell less sandwhiches but will rake in more money for every sandwhich.

If he is taxed, then he has to rethink his strategy. "I am now making less profit per sanwhich than I used to. Maybe I should raise the price a bit, because although less people will buy it now, I will get some of the profit back that the tax has eaten up on the ones that I do sell."

If his costs go down, and he is making more profit per sandwhich, he also rethinks., Maybe it's worth selling at the older lesser profit [cheaper] to get more people to buy."

because they are not fixed to those factors, but to subjective valorations and supply and demand

A request to the OP. Please let me know if this answers your q satisfactorily.

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