20: Tax Inefficiencies and Implications for Optimal Taxation

Question 1

What are the elements of a diagram showing the effect of a tax in equilibrium in a perfectly competitive market?

Answer 1

Axes: P & Q (Price per unit; Q)
- Demand Curve (Social Marginal Benefit - SMB): Benefit to society from consuming one good unit. SUM OF ALL INDIVIDUAL WTP.
- Supply Curve (Social Marginal Cost - SMC): Cost to society from producing a good (Private MC + externalities). SUM OF PRODUCERS’ WTA.
Equilibrium where SMC = SMB because WTP = WTA.