Chapter 8

laffer curve

a graph showing the relationship between the size of a tax and the tax revenue collected

deadweight loss is greatest when

both supply and demand are relatively elastic

the reduction of a tax

could increase tax revenue if the tax had been extremely high

as a tax on a good increases, what happens to tax revenue? why?

first tax revenue increases. at some point tax revenue decreases as the distortion in prices to buyers and sellers causes the market to shrink and large taxes collected on a small number of units exchanged

dead weight loss

the reduction in total surplus that results from a tax

would you expect a tax on gasoline to have a greater deadweight loss in the short run or long run? why?

there would be a greater deadweight loss in the long run. this is because both demand and supply tend to be more elastic in the long run as consumers and producers are able to substitute away from this market when prices move in an adverse direction. the more a market shrinks from a tax, the greater the deadweight loss

t/f a larger tax always generates a larger deadweight loss

true

a tax on gasoline is likely to

cause a greater deadweight loss in the long run when compared to the short run

when a tax distorts incentives to buyers and sellers so that fewer goods are produced and sold, the tax has

caused a deadweight loss

why does tax reduce consumer surplus?

consumer surplus is what the buyer is willing to pay for a good minus what the buyer actually pays and a tax raises the price the buyer actually pays

as a tax on a good increases, what happens to the deadweight loss from the tax? why?

deadweight loss increases continuously because as a tax increases the distortion in prices caused by the tax causes the market to shrink continuously. thus we fail to produce more and more units where the benefits to buyers exceed the costs to seller

t/f a tax will generate a greater deadweight loss if supply and demand are inelastic

false; a tax generates a greater deadweight loss when supply and demand are more elastic

t/f a larger tax always generate more tax revenue

false; as tax increases, revenue first rises and then falls as the tax shrinks the market to a point where all trades are eliminated and tax revenue is zero

t/f deadweight loss is the reduction in consumer surplus that results from a tax

false; deadweight loss is the reduction in total surplus that results from a tax

t/f a tax collected from buyers generates a smaller deadweight loss than a tax collected from sellers

false; taxes collected from either the buyers or the sellers are equivalent. that is why economists simply use a tax wedge when analyzing a tax and avoid the issue altogether

t/f when a tax is placed on a good, the revenue the government collects is exactly equal to the loss of consumer and producer surplus from the tax

false; the loss of producer and consumer surplus exceeds the revenue from the tax. the difference is deadweight loss

t/f a tax on cigarettes would likely generate a larger deadweight loss than a tax on luxury boats

false; the more elastic the demand curve, the greater the deadweight loss and the demand for cigarettes (a necessity) should be more inelastic than the demand for luxury boats (a luxury)

when a tax on a good starts small and is gradually increased, tax revenue will

first rise and then fall

under what conditions would a tax fail to produce a deadweight loss?

if either supply or demand were perfectly inelastic (insensitive to change in price), then a tax would fail to reduce the quantity exchanged and the market would not shrink

if a tax on a good is doubled, the deadweight loss from the tax

increases by a factor of four

the graph that shows the relationship between the size of a tax and the tax revenue collected by the government is known as a

laffer curve

suppose the supply of oil is relatively inelastic. would a tax on oil generate a large deadweight loss? why or why not? who would bear the burden of the tax, the buyer or the seller of oil? why?

no because the supply of oil is highly inelastic, the quantity supplied is not responsive to a decrease in the price received by the seller. the seller would bear the burden of the tax for the same reason-supply of oil is highly inelastic

when a tax is placed on a good, does the government collect revenue equal to the loss in total surplus due to tax? why or why not?

no. the tax distorts prices to buyers and sellers and causes them to reduce their quantities demanded and supplied. taxes are collected only on the units sold after the tax is imposed. those units that are no longer produced and sold generate no tax revenue, but those units would have added to total surplus because they are valued by buyers in excess of their cost to sellers. the reduction in total surplus is the deadweight loss

why does a tax generally produce a deadweight loss?

producer surplus is the amount the seller receives for a good minus the seller's cost and a tax reduces what the seller receives for a good

suppose the supply of diamonds is relaively inelastic. a tax on diamonds would generate a

small deadweight loss and the burden of the tax would fall on the seller of diamonds

tax wedge

the difference between what the buyer pays and the seller receives when a tax is placed on a market

t/f if John values having his hair cut at $20 and Mary's cost of providing the haircut is $10, any tax on haircuts larger than $10 will eliminate the gains from trade and cause a $20 loss of total surplus

the loss in total surplus is the buyer's value minus the seller's cost or $20-10=10

suppose Rachel values having her house painted at $1000. the cost for paul to paint her house is $700. what is the value of the total surplus or the gains from trade on this transaction? what is the size of the tax that would eliminate this trade? what is the deadweight loss from this tax? what generalization can you make from this exercise?

total surplus=$300 any tax larger than $300. deadweight loss would be $300 a tax that is greater than the potential gains from trade will eliminate trade and create a deadweight loss equal to the lost gains from trade

t/f a deadwight loss results when a tax causes market participants to fail to produce and consume units on which the benefits to the buyers exceed the cost to the sellers

true

t/f a tax causes deadweight loss because it eliminates some of the potential gains from trade

true

t/f if a tax is doubled, the deadweight loss fro the tax more than doubles

true

t/f if a tax is placed on a good and it reduces the quantity sold, there must be a deadweight loss from the tax

true

t/f if a tax is placed on a good in a market where supply is perfectly inelastic, there is no deadweight loss and sellers bear the entire burden of the tax

true

t/f if an income tax rate is high enough, a reduction in the tax rate could increase tax revenue

true

t/f in general, a tax raises the price the buyers pay, lowers the price sellers receive and reduces the quantity sold

true

taxes on labor income tend to encourage

workers to work fewer hours; second earners to stay home; the elderly to retire early; the unscrupulous to enter the underground ecconomy