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Taxes & Deadweight Loss
How Taxes, Subsidies and Externalities reduce efficiency Chapter 8
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TAXATION It does not matter if a tax is levied on buyers or sellers
The end result of a new tax is the same: Price paid by buyers ↑ Price received by sellers ↓ Quantity sold falls (the market shrinks!) Total Welfare falls
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Tax Wedge A tax places a wedge between the price buyers pay & the price sellers receive Because of this tax wedge, quantity sold falls below the natural market equilibrium (invisible hand) Overall, Total Welfare declines as the market shrinks
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The Effects of a Tax E1 price paid by consumers is higher
D = MB price received by firms is lower. S = MC Price buyers pay Price sellers receive Quantity with tax Size of tax (wedge) Who benefits? E1 Price without tax Quantity And the quantity declines. Quantity
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Gov’t Tax Revenue Gov’t tax revenue = Size of tax * quantity sold Tax
Price D = MB Gov’t tax revenue = Size of tax * quantity sold S = MC Quantity with tax Price buyers pay Price sellers receive Tax revenue (T × Q) Size of tax (T) Quantity without tax Quantity sold (Q) Quantity
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Total Welfare Analysis After Tax
Price A = New Consumer Surplus (before tax = A + B + C) D = MB S = MC = PB Q2 PS Price buyers pay sellers receive A F B D C E Tax Revenue = B + D Area C + E is a loss to Society: DEADWEIGHT LOSS (DWL) = P1 Q1 Price before tax E1 F = NewProducer Surplus (before tax = D + E + F) QTY
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Deadweight Loss Deadweight loss- the fall in total surplus that results from a tax or subsidy underproduction and overproduction both lead to deadweight loss Effective price ceilings & price floors also produce DWL TAX: DWL Example
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Total Welfare after Tax
New Total Welfare = New consumer surplus + New producer surplus + tax revenue Since the loss to buyers & sellers exceeds the tax revenue raised by the government, total welfare falls New Total Welfare= A + B + D + F
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Handout: Taxes & Deadweight Loss
Price $50 D = MB S = MC P2 50 P3 A F B D C E $40, P1 100 $30, $22, $14 Quantity
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