Microeconomics Ch. 8

Refer to the Figure. The loss of producer surplus as a result of the tax is

$100

Refer to the Figure. The amount of tax revenue received by the government is

$240

Refer to the Figure. The per-unit burden of the tax on buyers is

$4

Suppose a tax of $20 per unit is imposed on a good. The supply curve is a typical upward-sloping straight line, and the demand curve is a typical downward-sloping straight line. The tax decreases consumer surplus by $18,000 and decreases producer surplus by $18,000. The deadweight loss of the tax is $4,000. The tax decreased the equilibrium quantity of the good from

2,000 to 1,600

Why does a tax generally produce a deadweight loss?

A tax raises the price buyers pay and lowers the price sellers receive. This price distortion reduces the quantity demanded and supplied so we fail to produce and consume units where the benefits to the buyers exceed the cost to the sellers.

If a tax is placed on the product in this market, total surplus is the area

A+B+C+D

If there is no tax placed on the product in this market, total surplus is the area

A+B+C+D+E+F

If there is no tax placed on the product in this market, consumer surplus is the area

A+B+E

Refer to the figure. Panel (a) and panel (b) each illustrate a $1 tax placed on a market. Panel (b) illustrates an argument for a larger government.

False

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.

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

Refer to the Figure. The equilibrium price before the tax is imposed is

P2

Which of the following is true with regard to the burden of the tax in Exhibit 4?

The sellers pay a larger portion of the tax because supply is more inelastic than demand

Would you expect a tax on gasoline to have a greater deadweight loss in the short run or the 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.

Suppose Rachel values having her house painted at $1,000. 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.

A deadweight loss results when a tax causes market participants to fail to produce and consume units on which benefits to the buyers exceed the cost to sellers.

True

A larger tax always generates a larger deadweight loss

True

A tax causes a deadweight loss because it eliminates some of the potential gains from trade.

True

Refer to the Figure. Panel (a) and Panel (b) each illustrate a $1 tax placed on a market. In comparison to Panel (a), Panel (b) illustrates which of the following statements?

When supply is relatively elastic, the deadweight loss of a tax is larger than when supply is relatively inelastic.

Refer to the Figure. If the economy is at point N on the curve, then a decrease in the tax rate will

decrease the deadweight loss of the tax and increase tax revenue.

Relative to a situation in which hotel rooms are not taxed, the imposition of a tax on hotel rooms causes the equilibrium quantity of hotel rooms to

decrease, and the price buyers pay for hotel rooms to increase.

The size of the deadweight loss that results from a tax on cola is smaller, the

less time cola sellers have to adjust to the tax.

The deadweight loss from a $1 tax per unit will be largest in a market with a

long amount of time for sellers to adjust to a price change and many close substitutes.

If a tax is placed on the product in this market, consumer surplus is the area

A

For automotive oil, the supply curve is the typical upward-sloping straight line, and the demand curve is the typical downward-sloping straight line. A tax of $1.50 per liter is imposed on automotive oil. The tax reduces the equilibrium quantity in the market by 500 units. The deadweight loss from the tax is

$375

Laffer Curve

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

Which of the following would likely cause the greatest deadweight loss?

A tax on cruise line ticket

If a tax is placed on the product in this market, tax revenue paid by the buyers is the area

B

If a tax is placed on the product in this market, tax revenue paid by the sellers is the area

C

If there is no tax placed on the product in this market, producer surplus is the area

C+D+F

A tax on gasoline is likely to

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

Why does a tax reduce consumer surplus?

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

If a tax is placed on the product in this market, producer surplus is the area

D

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 sellers.

Refer the Scenario. Dominic plows Soraya's driveway for $85. Dominic's opportunity cost of plowing Soraya's driveway is $55, and Soraya's willingness to pay Dominic to plow her driveway is $100. Assume Dominic is required to pay a tax of $15 each time he plows a driveway. Which of the following results is most likely?

Dominic and Soraya still can engage in a mutually-agreeable trade.

If a tax is placed on the product in this market, deadweight loss is the area

E+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

A larger tax always generates more tax revenue

False-- as a 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.

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.

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.

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

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).

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 are collected on a small number of units exchanged.

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

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

Refer to the Figure. The curve that is shown on the figure is called the

Laffer Curve

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.

Will doubling the sales tax affect the tax revenue and the deadweight loss in all markets to the same degree? Explain.

No. Some markets may have extremely elastic supply-and-demand curves. In these markets, an increase in a tax causes market participants to leave the market, and little revenue is generated from the tax increase, but deadweight loss increases a great deal. Other markets may have inelastic supply-and-demand curves. In these markets, an increase in a tax fails to cause market participants to leave the market and a great deal of additional tax revenue is generated with little increase in deadweight loss.

When a tax is placed on a good, does the government collect revenue equal to the loss in total surplus due to the 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 were valued by buyers in excess of their cost to sellers. The reduction in total surplus is the deadweight loss.

Is it true that doubling tax will always double tax revenue? Why or why not?

No. Usually an increase in a tax will reduce the size of the market because the tax will increase the price to buyers, causing them to reduce their quantity demanded and will decrease the price to sellers, causing them to reduce their quantity supplied. Therefore, when taxes double, the government collects twice as much per unit on many fewer units, so tax revenue will increase by less than double and could, in some extreme cases, even go down.

Refer to the Figure. The price that sellers effectively receive after the tax is imposed is

P1

Why does a tax reduce producer surplus?

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.

Refer to the Figure. After the tax is levied, consumer surplus is represented by area

R

Refer to the Figure. Consumer surplus before the tax was levied is represented by area

R+S+U

Tax Wedge

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

Deadweight loss

The reduction in total surplus that results from a tax

If a tax is doubled, the deadweight loss from the tax more than doubles

True

If a tax is placed on a good and it reduces the quantity sold, there must be a deadweight loss from the tax

True

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

True

If an income tax rate is high enough, a reduction in the tax rate could increase tax revenue

True

In general, a tax raises the price the buyers pay, lowers the price the sellers receive, and reduces the quantity sold

True

Taxes on labor income tend to encourage

all of the above---- workers to work fewer hours, second earners to stay home, the elderly to retire early, and the unscrupulous to enter the underground economy

Deadweight loss is greatest when

both supply and demand are relatively elastic

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

caused a deadweight loss.

The reduction of a tax

could increase tax revenue if the tax had been extremely high

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

first rise and then fall

Refer to the Figure. Ronald Reagan made cutting taxes part of his platform when running for president in 1980 because

he believed the U.S. was operating at a point like point N.

Refer to the Figure. If the economy is at point M on the curve, then a small increase in the tax rate will

increase the deadweight loss of the tax and increase tax revenue.

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

increases by a factor of four

Suppose the supply of diamonds is relatively inelastic. A tax on diamonds would generate a

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

The benefit that government receives from a tax is measured by

tax revenue