Microeconomics Chapter 5

Assume that a $0.25/gallon tax on milk causes a loss of $250 million in consumer and producer surplus and creates a deadweight loss of $45 million. From this information, we know that the tax revenue from the tax is:

$205 million.

Assume that a $0.10/pound tax on apples raises $100 million in revenue but causes a $125 million loss of consumer and producer surplus. From this information, we know that the deadweight loss from the tax is:

$25 million.

When a tax is imposed on some good, what tends to happen to consumer prices and producer prices?

Consumer prices increase and producer prices decrease.

Explain what happens to the amount of consumer surplus and producer surplus when the supply of scarves suddenly declines (shifts left).

Consumer surplus declines and producer surplus declines.

Why is deadweight loss greater when goods with very elastic demands or supplies are taxed?

Deadweight loss is the result of firms or consumers changing their behavior in response to a tax. Consumers might respond by buying less of the taxed good and more of something else; firms might respond by producing less of the taxed good. If supply or demand is very elastic, the firms' or consumers' responses to the tax will be large, generating more deadweight loss.

Supply and demand both tend to become more elastic in the long run. What does this mean for the deadweight loss and tax revenue from a tax in the long run compared to the short run?

Deadweight loss will be larger in the long run and tax revenue will be smaller. This is because, in the long run, firms and consumers have a greater ability to respond to a tax, and supply and demand are more elastic. So the response to the tax will be greater, meaning that the deadweight loss will be greater and the tax revenue lower. In the short run, there is less ability to respond to taxes, so the revenue will be greater and the deadweight loss will be smaller.

Peanut butter and jelly are complements. If a tax is imposed on peanut butter, how will that affect the market for jelly?

Demand for jelly will decrease along with the price.

Explain why the elasticities of supply and demand determine who bears more of the burden of a tax, consumers or producers.

Elasticity measures responsiveness. Whichever party, consumers or producers, is more responsive to a tax will bear less of the burden of the tax. In extreme cases, when either supply or demand is perfectly elastic, the burden is borne by only one group.

True or False: An excise tax will always cause consumer prices to increase. Explain.

False. If demand for the good in question is perfectly elastic, consumer prices will not increase at all. The price effect of the tax will be felt entirely by firms in the form of lower prices received for their goods. Only if demand is at least somewhat inelastic will consumer prices increase.

The incidence of a tax is not determined by who pays the tax out of pocket. Explain why this is so.

If a tax is imposed on sellers, they can raise the price of the good they sell, thus shifting some of the incidence of the tax onto consumers. If a tax is imposed on consumers, they can choose to buy less of the good in question, thereby shifting some of the incidence of the tax onto producers. The ultimate bearer of the incidence of the tax depends on the relative elasticities of supply and demand.

The government is exploring ways to increase revenues through taxation. You are an economic adviser to public policy makers and they pose to you the following question: Should the government tax yachts or should it tax gasoline? Explain your answer using price elasticity of demand.

It is likely that yachts are a luxury good, whereas gasoline is a necessity. Demand will be more price elastic for the former good (yachts) and more price inelastic for the latter (gasoline). If the government raises taxes on gasoline, it is effectively raising the price, and because the demand is price inelastic, quantity demand will not change as much. Thus, the government will collect more tax revenues with a tax increase. A tax on yachts making them more expensive will reduce the quantity demanded by a more than proportional amount. Thus, tax revenues will fall.

Explain why goods that are necessities are often attractive targets for taxation by governments.

Necessities tend to have very inelastic demands, which means that consumers will change their behavior very little when the price of the necessity changes. This means that revenues from taxes on necessities are very stable. Furthermore, taxes on necessities generate very little deadweight loss.

Taxes cause consumers to lose consumer surplus and producers to lose producer surplus. Where does that surplus go?

The lost surplus ends up in two places. First, it is collected by the government as tax revenue from the party responsible for paying the tax out of pocket. Second, it is accounted for as deadweight loss, which is lost consumer and producer surplus.

In the long run, both supply and demand tend to become more elastic. This suggests that, in the long run, the:

deadweight loss from a tax will be greater than it is in the short run.

A tax on consumers would cause the __________curve(s) to shift to the __________.

demand; left

If the government wanted to raise taxes while generating the least amount of deadweight loss, it should raise taxes on a good with a:

perfectly inelastic demand.

A tax creates no deadweight loss only when either supply or demand is:

perfectly inelastic.

If a tax causes the supply curve to shift, we know that the tax is paid out of pocket by:

producers

A tax on apples would cause apple growers to suffer because:

revenues and profits from growing apples would decrease.

When a tax is imposed on some good, the lost consumer surplus and producer surplus both typically end up as:

tax revenue and deadweight loss.

In the long run, both supply and demand tend to become more elastic. This suggests that, in the long run, the:

tax revenue will be lower than it is in the short run.

Deadweight loss is defined as:

the cost to society created by distortions in the market.

Taxes will almost always cause consumer prices to increase. How much they increase depends on:

the elasticities of supply and demand.

A tax on apples would cause consumers to suffer because:

the price of apples would increase and fewer apples would be purchased.

Producer surplus is the difference between

the price the producer receives and the willingness to sell a good.

Consumer surplus is the difference between

the willingness to pay for a good and the amount that is paid to get it

The price-quantity combination found where the supply and demand curves intersect is a unique combination that is efficient because:

total surplus is maximized.

The incidence of a tax reflects:

who bears the burden of the tax.