Microeconomics Econ 101 Chapter 8: The Costs of Taxation Notes

Why does a tax have a deadweight loss?

A tax has a deadweight loss because it induces buyers and sellers to change their behaviour. The tax raises the price paid by buyers so they consume less. At the same time, the tax lowers the price received by sellers, so they produce less. Because of these changes in behaviour, the size of the market shrinks below the optimum.

What does a tax on a good cause?

It causes the size of the market for the good to shrink.

What do taxes cause?

Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.

Changes in Welfare

The change in total welfare includes the change in consumer surplus (which is negative), the change in producer surplus (which is negative), and the chance in tax revenue (which is positive). When added, these 3 pieces, help find the total surplus in the market. Thus, the losses to buyers and sellers from a tax exceed the revenue raised by the government. The fall in total surplus that results when a tax (or some other policy) distorts a market outcome is called the deadweight loss. When a tax raises the price to buyers and lowers the price to sellers, however, it gives buyers an incentive to consume less and sellers an incentive to produce less than they otherwise would. As buyers and sellers respond to these incentives, the size of the market shrinks below it's optimum. Thus because taxes distort incentives, they cause markets to allocate resources inefficiently.

Does the deadweight loss rise more than tax? If yes, why?

The deadweight loss of a tax rises even more rapidly than the size of the tax. The reason is that the deadweight loss is an area of a triangle, and an area of a triangle depends on the square of its size. If we double the size of the tax, for instance, the base and height of the triangle double, so the deadweight loss rises by a factor of 4. If we triple the size of a tax, the base and height triple, so the deadweight loss rises by a factor of 9.

What happens when a tax is levied on buyers?

The demand curve shifts downward by the size of the tax, when it is levied on sellers, the supply curve shifts upward by that amount. In either case, when the tax is enacted, the price paid by buyers rises and the price received by sellers falls. In the end, buyers and sellers share the burden of tax regardless of how its levied.

How does elasticity of supply affect the size of deadweight loss?

The demand curve, and the size of the tax are the same. The difference is in the elasticity of the supply curve. When the supply curve is relatively elastic, the quantity supplied responds substantially to changes in the price. When the supply curve is relatively inelastic, the quantity supplied responds only slightly to changes in the price. When the supply curve is more elastic, the deadweight loss, or the area of the triangle between the supply and demand curves is larger.

What do elasticities of supply and demand measure?

The elasticities of supply and demand measure how much sellers and buyers respond to the changes in the price and, therefore, determine how much the tax distorts the market outcome. Hence, the greater the elasticities of supply and demand, the greater the deadweight loss of a tax.

Deadweight Loss

The fall in total surplus that results from a market distortion, such as a tax. The deadweight loss is the surplus lost because the tax discourages these mutually advantageous trades.

Welfare without a Tax

The price and quantity are found at the intersection of the supply and demand curves. Because there is no tax, there is no tax revenue.

What determines whether the deadweight loss from a tax is large or small?

The price elasticities of supply and quantity demanded respond to the changes in price.

Welfare with a Tax

The price paid by buyers rises from P1 to PB, so consumer surplus now equals the area below the demand curve and above the buyers price. The price received by sellers falls from P1 to PS, so producer surplus now equals only the area above the supply curve and below the seller's price. The quantity sold falls from Q1 to Q2, and the government collects tax revenue, which is T X Q.

What is the government's tax revenue?

The size of the tax times the amount of the good sold.

Tax Revenue

The tax revenue that the government collects T X Q, the size of the tax T times the quantity sold Q. Thus, tax revenue equals the area of the rectangle between the supply and demand curves. The government's tax revenue is represented by a rectangle between the supply and demand curves. The height is the size of the tax, T, and the width is the quantity of the good sold, Q. Hence, T X Q = Tax Revenue.