08 Application: The Costs of Taxation
08 Application: The Costs of Taxation
08 Application: The Costs of Taxation
Costs of Taxation
Copyright2004 South-Western
Price
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
Quantity
with tax
Quantity
without tax
Quantity
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Supply
Price buyers
pay
Tax
revenue
(T Q)
Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
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Price
Price
buyers = PB
pay
Supply
Price
without tax = P1
Price
sellers = PS
receive
D
F
Demand
Q2
Q1
Quantity
Lost gains
from trade
PB
Supply
Size of tax
Price
without tax
PS
Cost to
sellers
Value to
buyers
0
Q2
Demand
Quantity
Q1
Reduction in quantity due to the tax
DETERMINANTS OF THE
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.
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax
Supply
Demand
0
Quantity
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0
Quantity
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Supply
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
Quantity
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DETERMINANTS OF THE
DEADWEIGHT LOSS
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.
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
Q2
Q1 Quantity
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PB
Supply
Tax revenue
PS
Demand
Q2
Q1 Quantity
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Tax revenue
Deadweight
loss
Supply
Demand
PS
0
Q2
Q1 Quantity
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Tax Size
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Tax Size
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Summary
A tax on a good reduces the welfare of buyers
and 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.
Summary
Taxes have a deadweight loss because they
cause buyers to consume less and sellers to
produce less.
This change in behavior shrinks the size of the
market below the level that maximizes total
surplus.
Summary
As a tax grows larger, it distorts incentives
more, and its deadweight loss grows larger.
Tax revenue first rises with the size of a tax.
Eventually, however, a larger tax reduces tax
revenue because it reduces the size of the
market.