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Figure 1 The Effects of a Tax

Copyright © 2004 South-Western

Size of tax

Quantity0

Price

Price buyers

pay

Price sellers

receive

Demand

Supply

Price

ithout tax

!uantity

ithout tax

!uantity

ith tax

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Copyright © 2004 South-Western/Thomson Learning

"o a Tax #ffects $ar%et Participants

• 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 maret for that good shrins.

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• Tax !evenue

• T = the size of the tax

• Q = the quantity of the good sold

T T QQ = the government’s tax revenue= the government’s tax revenue

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Figure & Tax 'evenue


Taxrevenue

(T ) !*

Size of tax (T *

!uantity

sold (Q*

Quantity0

Price

Demand

Supply

!uantity

ithout tax

!uantity

ith tax

Price buyers

pay

Price sellers

receive

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Figure + "o a Tax Effects ,elfare


#

F

-

D

.

E

Quantity0

Price

Demand

Supply

/ P B

Q&

/ P S

Pricebuyers

pay

Pricesellers

receive

/ P 1

Q1

Priceithout tax

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• "hanges in #elfare

• A deadweight loss is the fall in total surplus that

results from a maret distortion, such as a tax.

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"o a Tax #ffects ,elfare

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• 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 deadweightloss.

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9/29Copyright © 2004 South-Western/Thomson Learning

Deadeight osses and the ains fromTrade

• Taxes cause deadweight losses because they

prevent buyers and sellers from realizing some

of the gains from trade.

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Figure 2 The Deadeight oss


.ost to

sellers3alue to

buyers

Size of tax

Quantity0

Price

Demand

Supplyost gains

from trade

'eduction in 4uantity due to the tax

Priceithout tax

Q1

P B

Q&

P S

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DETE'$56#6TS 7F T"EDE#D,E5"T 7SS

• #hat 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 quantitydemanded respond to changes in the price.

• That, in turn, depends on the price elasticities price elasticities of

supply and demand.

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Figure 8 Tax Distortions and Elasticities


(a) ne!astic Supp!y

Price

0 Quantity

Demand

Supply

Size of tax

,hen supply isrelatively inelastic9

the deadeight loss

of a tax is small:

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(") #!astic Supp!y

Price

0 Quantity

Demand

SupplySize

of

tax

,hen supply is relatively

elastic9 the deadeight

loss of a tax is large:

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Demand

Supply

(c) ne!astic $eman%

Price

0 Quantity

Size of tax

,hen demand is

relatively inelastic9

the deadeight loss

of a tax is small:

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(%) #!astic $eman%

Price

0 Quantity

Size

of

tax Demand

Supply

,hen demand is relatively

elastic9 the deadeight

loss of a tax is large:

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DETE'$56#6TS 7F T"EDE#D,E5"T 7SS

• 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.

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DE#D,E5"T 7SS #6D T#;'E3E6

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Figure > Deadeight oss and Tax 'evenue from ThreeTaxes of Different Sizes


Tax revenue

Demand

Supply

Quantity0

Price

Q1

(a) Sma!! Ta&

Deadeight

lossP B

Q&

P S

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Tax revenue

Quantity0

Price

(") 'e%ium Ta&

P B

Q&

P S

Supply

Demand

Q1

Deadeight

loss

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T a x

r e v e n u e

Demand

Supply

Quantity0

Price

Q1

(c) Large Ta&

P B

Q&

P S

Deadeight

loss

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Figure ? "o Deadeight oss and Tax 'evenue 3ary iththe Size of a Tax


(a) $ea%eight Loss

$ea%eight

Loss

0 Ta& Sie

Fi " D d i h d T ' 3 i h

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Figure ? "o Deadeight oss and Tax 'evenue 3ary iththe Size of a Tax


(") *e+enue (the La,,er cur+e)Ta&

*e+enue

0 Ta& Sie

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.#SE ST

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Summary

• A tax on a good reduces the welfare of buyersand sellers of the good, and the reduction in

consumer and producer surplus usually exceeds

the revenues raised by the government.• The fall in total surplusthe sum of consumer

surplus, producer surplus, and tax revenue is

called the deadweight loss of the tax.

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Summary

• Taxes have a deadweight loss because theycause buyers to consume less and sellers to

produce less.

• This change in behavior shrins the size of themaret below the level that maximizes total

surplus.

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Summary

• As a tax grows larger, it distorts incentivesmore, and its deadweight loss grows larger.

• Tax revenue first rises with the size of a tax.

• +ventually, however, a larger tax reduces tax

revenue because it reduces the size of the

maret.

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