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What is the deadweight loss of a tax? What factors determine the size of this deadweight
loss?
Size of tax = $T
PB PE PS D S
QE
Q
5
Size of tax = $T
S
QT
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QE
Q
6
CS = A + B + C
PS = D + E + F Tax revenue = 0
A B PE C E D F S
QT
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QE
Q
8
A PB B C E
D
PS F
QT
QE
Q
9
C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax.
A PB B C E
D
PS F
QT
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QE
Q
10
PB
PS
QT
QE
Q
11
$400
350 300 250 200 150 100 50 0 0 25
airplane tickets
per ticket, compute CS, PS, tax revenue, total surplus, and DWL.
D
Q
50 75 100 125
12
D Q
75 100 125
13
PB = 250
200
PS = 150
100 50 0 0 25 50 75 100 125
14
D
Q
One answer: those with the smallest DWL. When is the DWL small vs. large?
Turns out it depends on the price elasticities of supply and demand.
Recall:
The price elasticity of demand (or supply) measures how much QD (or QS) changes when P changes.
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Size of tax
D
Q
16
Size of tax
D
Q
17
When demand is inelastic, its harder for consumers to leave the market when the tax raises PB. So, the tax only reduces Q a little,
Q
Size of tax
The more elastic is demand, the easier for buyers to leave the market when the tax increases PB, the more Q falls below the surplusmaximizing quantity, and the greater the DWL.
19
Size of tax
D
20
From Chapter 5: Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger DWL than a tax on groceries.
21
22
24
26
new DWL
S
2T
T
D
initial DWL
Q2
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Q1
Q
27
new DWL
S
3T
T
D
initial DWL
Q3
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Q1
Q
28
When tax rates are low, raising them doesnt cause much harm, and lowering them doesnt bring much benefit.
When tax rates are high, raising them is very harmful, and cutting them is very beneficial.
Tax size
29
PB PB
2T
PS PS
T
D
Q2
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Q1
Q
30
3T
2T
D
PS PS
Q3
Q2
Q
31
Tax size
32
CHAPTER SUMMARY
A tax on a good reduces the welfare of buyers and
sellers. This welfare loss usually exceeds the revenue the tax raises for the govt.
CHAPTER SUMMARY
The price elasticities of demand and supply
measure how much buyers and sellers respond to price changes. Therefore, higher elasticities imply higher DWLs.