Alfred Marshall Taxes and Welfare

Alfred Marshall Taxes and Welfare

Marshall used his concept of consumers' surplus to analyze the welfare consequences of taxes. The essence of the analysis can be appreciated by examining the simplest case, a constant-cost industry, represented by the perfectly elastic supply curve shown in Figure Assume that the industry is in equilibrium, with demand being DD', supply SS', and price HA. Consumers' surplus is SDA. Now a tax of Ss is levied, shifting the supply curve to 55'. The loss of consumers' surplus is SsaA, and the gain in tax revenues is SsaK. The loss in consumers' surplus is greater than the gain in revenues by KaA. Taxes on constant-cost industries, therefore, appear undesirable. The analysis can be similarly used to show that a subsidy to a constant-cost industry is undesirable, because its net costs would be greater than its net benefits. Assume that demand is DD', supply is ss', and price is ha. A subsidy in the amount of Ss will shift the supply curve downward to SS'. The gain in consumers' surplus is SsaA, which is AaL less than the total expenditure for the subsidy SsLA.



Taxes, Subsidies and Consumers' Surplus


Marshall then extended the analysis to cover industries with diminishing returns (upward-sloping supply curves) and those with increasing returns (down­ward-sloping supply curves).18 Assuming that decreasing returns exist, a tax will result in increased welfare if the supply curve is sloped steeply enough that the gain in the tax is greater than the loss in consumers' surplus. In the same way, a subsidy to a decreasing-cost industry will increase welfare, because the gain in consumers' surplus will be greater than the cost of the subsidy. Marshall thus concluded that there might be advantages to the society from taxing certain decreasing-returns industries and using the collected revenues to subsidize increasing-returns industries. Since the entire analysis rests on the dubious notion that utility can be measured by consumers' surplus, its practical value in making policy is questionable. Marshall's purpose in presenting the analysis was not so much to give a set of precise rules for taxes and subsidies as to show that unregulated markets do not always result in an optimum allocation of resources. A. C. Pigou took these seminal suggestions to form an extended theory of welfare economics.