Taxes

1
Taxes Deadweight Loss
How Taxes, Subsidies and Externalities reduce
efficiency

• Chapter 8

2
EFFICIENCY vs. EQUITY

• Efficiency an allocation which maximizes the
  Total Surplus
• Total Surplus Consumer Surpuls Producer
  Surplus
• Market equilibrium maximizes Total Surplus (or
  Welfare)
• assuming no externalities, price collusion,
  fraud, etc.
• Equity the fairness of the distribution of
  well-being among various buyers and sellers
• Equity is not addressed in free markets

3
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!)

4
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

5
The Effects of a Tax
Price
price paid by consumers is higher
price received by firms is lower.
Who benefits?
E1
And the quantity declines.
Quantity
0
6
Govt Tax Revenue
Price
Govt tax revenue Size of tax quantity sold
Quantity
0
7
Total Welfare before Tax
Price

E1


0
QTY
8
Deadweight Loss

• Deadweight loss- the fall in total surplus that
  results from a tax
• underproduction and overproduction both lead to
  deadweight loss

Taxes reduce production
Therefore, with all taxes Society incurs
a Deadweight Loss!
9
Total Welfare After Tax
Price



Quantity
0
10
Handout Taxes Deadweight Loss
Price



Quantity
0
11
Total Welfare with Tax

• Total Welfare (Surplus) include the sum of
• Adjusted consumer surplus
• Adjusted producer surplus
• Increase in tax revenue
• The loss to buyers sellers exceed the revenue
  raised by the government
• Therefore, unless you are correcting an
  externality, when taxes increase, Total Surplus
  falls