Embed Size (px)
DESCRIPTION
APPLICATIONS OF WELFARE ECONOMICS: THE COST OF TAXATION. Overview. How do taxes affect the economic well-being of market participants? We can use the tools of welfare economics (consumer and producer surplus) to answer that question. - PowerPoint PPT Presentation
Citation preview
APPLICATIONS OF WELFARE ECONOMICS:THE COST OF TAXATION
Overview
• How do taxes affect the economic well-being of market participants?
– We can use the tools of welfare economics (consumer and producer surplus) to answer that question.
• In chapter 6 we learned that it does not matter whether a tax on a good is levied on buyers or sellers of the good . . . the price paid by buyers rises, and the price received by sellers falls.
• In this chapter we examine the “Distortions” and welfare losses in markets subject to taxation
How a Tax Affects Market 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 market for that good shrinks.
• As a result, there is a loss in consumer and producer surplus.
• That loss is known as the deadweight loss of taxation
Deadweight Loss of Taxation
Quantity
Price
D1
S1
PD
PS
P1
Q1
A per-unit tax drives a wedge between the price
paid by consumers and the price received by
suppliers. As a result, output falls as does
consumer and producer surplus
Tax Wedge
QTax
Loss in Consumer Surplus
Loss in Producer Surplus
Deadweight Loss of Taxation
Quantity
Price
D1
S1
PD
PS
P1
Q1QTax
The area to the left of the tax wedge represents
government tax revenue, the area to the right of the tax wedge represents the
deadweight loss of taxation
Tax RevenueDeadweight loss of
taxation
Deadweight Loss of Taxation
Quantity
Price
D1
S1
PD
PS
P1
Q1QTax
A
BC
D E
F
Consumer Surplus without tax: A+B+C
Producer Surplus without tax: D+E+F
Consumer Surplus with tax: A
Producer Surplus with Tax: F
Government tax Revenue: B+D
Deadweight loss of taxation: C+E
How a Tax Affects Welfare
How a Tax Affects Market Participants
• 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 deadweight loss.
The Magnitude of 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 elasticitiesprice elasticities of supply and demand.
The Magnitude of 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.
• The smaller the elasticities of demand and supply:
– the smaller will be the decline in equilibrium quantity and,
– the smaller the deadweight loss of a tax.
Deadweight Loss: Inelastic Supply & Demand
P
Q
D
S
P1
Q1Qt
Deadweight Loss (DWL)tax
When demand and/or supply is
inelastic, the deadweight loss
of taxation is small
Deadweight Loss: Elastic Supply & Demand
P
Q
D
S
P1
Q1Qt
Deadweight Loss (DWL)
tax
When demand and/or supply is
elastic, the deadweight loss
of taxation is large
Deadweight Loss and the Size of a Tax
• With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.
– Doubling the tax rate will more than double the deadweight loss of taxation
Deadweight Loss with a Small Sized Tax
P
0 Q
D
S
P1
Q1
Per Unit Tax
Qt
PD
PS
Deadweight Loss (DWL)
Tax Revenue
Deadweight Loss with a Medium Sized Tax
P
0 Q
D
S
P1
Q1
Per Unit Tax
Qt
PD
PS
Deadweight Loss (DWL)
Tax Revenue
Deadweight Loss with a Large Sized Tax
P
0 Q
D
S
P1
Q1
Per Unit Tax
Qt
PD
PS
Deadweight Loss (DWL)
Tax Revenue
The Relationship Between Deadweight Loss and the Size of a Tax
DeadweightLoss
0 Tax Size
