A PPLICATIONS : D EADWEIGHT L OSS ETP Economics 101

D EADWEIGHT L OSS Changes in Welfare A deadweight loss is the fall in total surplus that results from a market distortion, such as government regulations on prices and tax.

PRICE REGULATION Case 1: Rent control Case 2: Minimum wage

supply demand b equilibrium excess demand Quantity (Thousand units a month) Price ($ per month) RENT CONTROL: EQUILIBRIUM

supply demand b Quantity (Thousand units a month) Price ($ per month) Rent Control: Surpluses d g e Consumer surplus gain = cfeg Consumer surplus loss = dgb Producer surplus loss = cfeg + geb Deadweight loss=dgb+geb c f

supply demand a b c equilibrium excess supply Quantity (Billion worker-hours a week) Wage ($ per hour) MINIMUM WAGE: EQUILIBRIUM 4.00

supply demand a b c Quantity (Billion worker-hours a week) Wage ($ per hour) Minimum Wage: Surpluses 4.00 f d e g seller (employee) surplus gain = fdge seller (employee) surplus loss = ghb buyer (employer) surplus loss = fdge + egb Deadweight loss=ghb+egb h

The Deadweight Loss of Taxation Tax on a good Levied on buyers Demand curve shifts downward by the size of tax Levied on sellers Supply curve shifts upward by the size of tax Same outcome: price wedge Price paid by buyers – rises Price received by sellers – falls Lower quantity sold 8

The Deadweight Loss of Taxation Tax burden Distributed between producers and consumers Determined by elasticities of supply and demand Market for the good - smaller 9

The effects of a tax 10 Price Quantity 0 Demand Supply Price buyers pay Price without tax Price sellers receive Size of tax A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls. Quantity with tax Quantity without tax

T AX W EDGE A tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. The size of the market for that good shrinks.

T HE D EADWEIGHT L OSS OF T AXATION How a tax affects market participants Gains and losses from a tax on a good Buyers: consumer surplus Sellers: producer surplus Government: total tax revenue Tax times quantity sold Public benefit from the tax 12

F IGURE 2 T AX R EVENUE Copyright © 2004 South-Western Tax revenue (T × Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive

H OW A TAX AFFECTS WELFARE 14 Price Quantity 0 Demand Supply A tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E). A B D F Q1Q1 C E Price sellers receive =P S Price without tax =P 1 Price buyers pay =P B Q2Q2 Without TaxWith TaxChange Consumer Surplus Producer Surplus Tax Revenue Total Surplus A+B+C D+E+F None A+B+C+D+E+F A F B+D A+B+D+F -(B+C) -(D+E) +(B+D) -(C+E) The area C + E shows the fall in total surplus and is the deadweight loss of the tax

T HE D EADWEIGHT L OSS OF T AXATION Losses of surplus to buyers and sellers from a tax Exceed the revenue raised by the government Deadweight loss Fall in total surplus that results from a market distortion, such as a tax Taxes distort incentives Markets allocate resources inefficiently 15

D ETERMINANTS OF D EADWEIGHT L OSS What determines whether the deadweight loss from a tax is large or small? The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. price elasticities That, in turn, depends on the price elasticities of supply and demand.

D ETERMINANTS OF D EADWEIGHT L OSS The greater the elasticities of demand and supply: the larger will be the decline in equilibrium quantity and, the greater the deadweight loss of a tax.

F IGURE 5 T AX D ISTORTIONS AND E LASTICITIES Copyright © 2004 South-Western (a) Inelastic Supply Price 0Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small.

F IGURE 5 T AX D ISTORTIONS AND E LASTICITIES Copyright © 2004 South-Western (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large.

F IGURE 5 T AX D ISTORTIONS AND E LASTICITIES Copyright © 2004 South-Western Demand Supply (c) Inelastic Demand Price 0 Quantity Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.

F IGURE 5 T AX D ISTORTIONS AND E LASTICITIES Copyright © 2004 South-Western (d) Elastic Demand Price 0 Quantity Size of tax Demand Supply When demand is relatively elastic, the deadweight loss of a tax is large.

D EADWEIGHT L OSS AND T AX R ATE With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.

40% labor tax - Small or large deadweight loss? Labor supply - fairly inelastic Almost vertical Tax on labor - small deadweight loss Labor supply - more elastic Tax on labor – greater deadweight loss T HE DEADWEIGHT LOSS DEBATE 23

T AX R EVENUE AND T AX R ATE For the small tax, tax revenue is small. As the size of the tax rises, tax revenue grows. But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market.

F IGURE 6 D EADWEIGHT L OSS AND T AX R EVENUE FROM T HREE T AXES OF D IFFERENT S IZES Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (a) Small Tax Deadweight loss PBPB Q2Q2 PSPS

F IGURE 6 D EADWEIGHT L OSS AND T AX R EVENUE FROM T HREE T AXES OF D IFFERENT S IZES Copyright © 2004 South-Western Tax revenue Quantity 0 Price (b) Medium Tax PBPB Q2Q2 PSPS Supply Demand Q1Q1 Deadweight loss

F IGURE 6 D EADWEIGHT L OSS AND T AX R EVENUE FROM T HREE T AXES OF D IFFERENT S IZES Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (c) Large Tax PBPB Q2Q2 PSPS Deadweight loss

F IGURE 7 H OW D EADWEIGHT L OSS AND T AX R EVENUE V ARY WITH THE S IZE OF A T AX Copyright © 2004 South-Western Deadweight Loss 0 Tax Size

F IGURE 7 H OW D EADWEIGHT L OSS AND T AX R EVENUE V ARY WITH THE S IZE OF A T AX Copyright © 2004 South-Western Tax Revenue 0 Tax Size

D EADWEIGHT L OSS & T AX R EVENUE AS T AXES V ARY As the tax increases Deadweight loss increases Even more rapidly than the size of the tax Tax revenue Increases initially Then decreases Higher tax – drastically reduces the size of the market 30

L AFFER C URVE AND S UPPLY - SIDE ECONOMICS The Laffer curve depicts the relationship between tax rates and tax revenue. Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues.

1974, economist Arthur Laffer Laffer curve Supply-side economics Tax rates were so high Reducing them would actually raise tax revenue Ronald Reagan - ran for president in 1980 From experience in film industry High tax rates - caused less work Low tax rates - caused more work T HE L AFFER CURVE AND SUPPLY - SIDE ECONOMICS 32

Ronald Reagan - ran for president in 1980 Argument Taxes were so high that they were discouraging hard work Lower taxes would give people the proper incentive to work Raise economic well-being Perhaps increase tax revenue Economists continue to debate Laffer’s argument General lesson: Change in tax revenue from a tax change Depends on how the tax change affects people’s behavior T HE L AFFER CURVE AND SUPPLY - SIDE ECONOMICS 33