ECON 1110
Professor Thomas
Fall 2016
Week 6: Lecture 2 of 2
Thursday, September 29th, 2016
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Key Questions:
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How does a tax affect consumer surplus, producer surplus, and total surplus
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What is the deadweight loss of a tax?
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What factors determine the size of the deadweight loss?
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How does tax revenue depend on the size of the tax?
Equilibrium with no tax ○
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With no tax, the market equilibrium is at Q and P
Effects of Tax $T
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This moves us away from equilibrium ○
Consumers and producers end up on either side of the equilibrium price ○
Consumers pay above equilibrium price while producers pay below ○
With a per unit tax of $T:
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Buyers pay Pb
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Sellers receive Ps
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The quantity exchanged is equal to Qt
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At a price of Ps, producers are only will to provide a quantity of Qt
Quantity demanded goes down because of higher price
iClicker —B
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take the amount of units you sell Qt and for each of those Qt units we generate $T in
revenue ○
Vertical distance between Pb and Ps is the new Tax
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the shaded area is the revenue generated by the tax
iClicker —D
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Surplus without a Tax:
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Consumer Surplus = A +B+C
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Producer Surplus = D+E+F
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Total Surplus = CS+PS = A+B+C+D+E+F
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If we are at equilibrium quantity and price Surplus with a $T Tax:
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Because we are exchanging fewer units, a reduction in the total surplus ○
Due to the tax, we result with a smaller total surplus The Effects of a Tax
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C+E is the deadweight loss (DWL)
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Consumers loses C
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Producers loses E
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market distortions happen when we artificially impose something on the market forcing
it out of equilibrium ○
This is the reduction in total surplus that results from a market distortion such as a tax
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like taxes, binding price ceiling/floors, quotas are market distortions
The Deadweight Loss
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Because of the tax, the units between Qt and Q* are not sold
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There are producers who would take part in the market if there was no tax
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there are consumers who are willing and able to buy if there was no tax that stopped
them
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Imposing tax reduces the quantity of exchange and stop mutually beneficial exchanges
from happening Deadweight Loss
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The elasticy of demand and elasticity of supply determine the size of the deadweight
loss
DWL and Elasticity of Supply
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When supply is inelastic, consumers are going to be less responsive to price change
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Size of the tax becomes small ○
When supply is inelastic, its harder for firms to leave the DWL and Elasticity of Supply
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The more elastic supply, the easier for firms to ○
Producers are more responsive to the tax because its more elastic, they’re more responsive to the tax and price
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This means the deadweight loss will be greater
DWL and Elasticity of Demand
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If demand is inelastic, its harder for consumers to leave the market when tax increases
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Effect of this is that the tax reduces Q by a small amount, and the deadweight loss is
small
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If demand curve is elastic
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There is a greater deadweight loss
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It all has to do with the elasticities of demand and supply that affect deadweight
loss
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Elasticities matter in the size of the tax revenue, overall deadweight loss, Change the size of the Tax?
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Initially, tax is $T per unit
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Doubling the tax causes the DWL to more than double ○
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Tripling the tax causes the DWL to more than triple Revenue and the Size of the Tax
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Revenue the government collects is going to differ based onteh shapes and slopes of the
demand supply functions
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When the tax is small increasing it causes tax revenue to rise ○
When the tax is large, increasing it causes tax revenue to fall
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Some people drop out of the market
The Laffer Curve
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Size of the tax and amount o f tax revenue generated
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Not too big, not too small, gotta be just right
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To maximize tax revenue, we should be sort of in the middle of the curve