1. Chapter 8 notes

2. Figure 1 The Effects of a Tax
Price
The price paid by consumers is higher
Demand
The price received by firms is lower.
Supply
Price buyers
pay
Price sellers
receive
Quantity
with tax
Size of tax
Who benefits?
Price
without tax
Quantity
And the quantity declines.
Quantity

3. Tax Revenue T = the size of the tax Q = the quantity of the good sold
T  Q = the government’s tax revenue

4. Figure 2 Tax Revenue Price Demand Supply Quantity with tax
Price buyers
pay
Price sellers
receive
Tax
revenue
(T × Q)
Size of tax (T)
Quantity
without tax
Quantity
sold (Q)
Quantity

5. Welfare, Taxes and Total Surplus
Without tax – market is at equilibrium; total surplus is area between the S and D curves up to EQ
With tax – total surplus = new consumer surplus + tax revenue + new producer surplus

6. Deadweight Loss
When taxes are enacted, buyers and sellers are worse off and gov’t is better off
Total surplus falls
Deadweight Loss = the fall in total surplus b/c of a distortion such as a tax
Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade

7. Figure 3 How a Tax Effects Welfare
Price
Demand
Supply = PB Q2 PS
Price
buyers
pay
sellers
receive A F B D C E = P1 Q1
Price
without tax
Quantity

8. Change in total welfare
The change in total welfare includes:
The change in consumer surplus,
The change in producer surplus, and
The change in tax revenue.
The losses to buyers and sellers exceed the revenue raised by the government.
This fall in total surplus is called the deadweight loss.

9. Figure 4 The Deadweight Loss
Price
Demand
Supply
Lost gains
from trade PB Q2 PS
Size of tax
Price
without tax Q1
Cost to
sellers
Value to
buyers
Quantity
Reduction in quantity due to the tax

10. Determinants of Deadweight Loss
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.
That, in turn, depends on the price elasticities of supply and demand.

11. Figure 5 Tax Distortions and Elasticities
(a) Inelastic Supply
Price
Demand
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Quantity

12. Figure 5 Tax Distortions and Elasticities
(b) Elastic Supply
Price
Demand
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size of
tax
Supply
Quantity

13. Figure 5 Tax Distortions and Elasticities
(c) Inelastic Demand
Price
Supply
Demand
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Quantity

14. Figure 5 Tax Distortions and Elasticities
(d) Elastic Demand
Price
Supply
Demand
Size of
tax
When demand is relatively
elastic, the deadweight
loss of a tax is large.
Quantity

15. Size of DWL 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.

16. The Deadweight Loss Debate
Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic.
Some examples of workers who may respond more to incentives:
Workers who can adjust the number of hours they work
Families with second earners
Elderly who can choose when to retire
Workers in the underground economy (i.e., those engaging in illegal activity)

17. DWL and Tax Revenue
With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.
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.

18. Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of the Tax
(a) Small Tax
Price
Demand
Deadweight
loss
Supply PB Q2 PS
Tax revenue Q1
Quantity

19. Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of the Tax
(b) Medium Tax
Price
Demand
Deadweight
loss PB Q2 PS
Tax revenue
Supply Q1
Quantity

20. Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of the Tax
(c) Large Tax
Price PB Q2 PS
Demand
Tax revenue
Deadweight
loss
Supply Q1
Quantity

21. As the size of a tax increases, its deadweight loss quickly gets larger.
By contrast, tax revenue first rises with the size of a tax, but then, as the tax gets larger, the market shrinks so much that tax revenue starts to fall.

22. Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax
(a) Deadweight Loss
Deadweight
Loss
Tax Size

23. CASE STUDY: The Laffer Curve and Supply-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.

24. Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax
(b) Revenue (the Laffer curve)
Tax
Revenue
Tax Size