Elasticity & Deadweight Loss

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Presentation transcript:

Elasticity & Deadweight Loss How large is the loss to society of taxes? Chapter 8

Taxes When a good is taxed => Buyers & sellers both bear some of the tax burden 2 Types of Taxes: Sales Tax: % tax on most goods 8.0% in California Excise Tax: per unit taxes on specific goods (ex: cigarettes, gasoline, etc…) $0.50 per gallon of gas, $2.87 per pack of cigarettes (California) 2 Reasons to Tax: To ↑ Government Revenue and/or To ↓ Consumption of a good (negative externalities, i.e. cigarettes) 22 30

Excise Tax Per pack of Cigarettes New York 1st = $4.35 per pack Missouri last = $0.18 California 8th = $2.87 Elasticity? Px ↑ 10% => Qty D ↓ 4% Ed = 0.4 is inelastic Taxing cigarettes the “correct amount” will not cause DWL => Smoking is considered a negative externality. (mkt failure)

DETERMINANTS OF DEADWEIGHT LOSS The magnitude of deadweight loss depends on how much the quantity supplied & quantity demanded change i.e. how much does the market shrink with a tax Magnitude of changes in quantity supplied/demanded, in turn, depend on the price elasticities of supply and demand

Tax & DWL Summary Taxes cause DWL because the size of a market shrinks (Qty ↓) Elastic curves => lead to a larger ↓ Qty from a tax => therefore: DWL is large & Tax Revenue small Inelastic curves => lead to a smaller ↓ Qty from a tax => therefore: DWL is small & Tax Revenue is large Inelastic Demand Elastic Demand

DWL, Tax Revenue &Elasticity Elastic Supply Inelastic Supply Inelastic Demand ELASTIC = LARGE deadweight loss Small Tax Revenue INELASTIC = SMALL deadweight loss Large Tax Revenue Elastic Demand

Worksheet: Excise Taxes & Deadweight Loss Price T-Shirts $20 S1 -------------- $10 E1 ------------- D1 2,000 Qty