WEEK 4 - Chapter 8: Application - The Costs Of Taxation Flashcards
What is deadweight loss?
The reduction in total surplus that results from a market distortion such as a tax or a monopoly price.
The determinants of deadweight loss.
The answer is the price elasticities of supply and demand, which measure how much the quantity supplied and quantity demanded respond to changes in the price.
A tax has a deadweight loss because it induces buyers and sellers to change their behaviour. The tax raises the price paid by buyers, so they consume less. At the same time, the tax lowers the price received by sellers, so they produce less.
Because of these changes in behaviour, the equilibrium quantity in the market shrinks below the optimal quantity. The more responsive buyers and sellers are to changes in the price, the more the equilibrium quantity shrinks. Hence, the greater the elasticities of supply and demand, the greater the deadweight loss of a tax.
How deadweight loss and tax revenue vary with the size of the tax.
As the size of a tax grows larger, the deadweight loss grows larger. (On a graph this curve increases exponentially)
Tax revenue first rises with the size of the tax; but then, as the tax increases further, the market shrinks so much that tax revenue starts to fall. This relationship is sometimes called the Laffer curve (on a graph this curve looks line an upside down U).
Conclusion.
It has been said that taxes are the price we pay for a civilised society. Indeed, our society cannot exist without some form of taxes. We all expect the government to provide us with certain services, such as roads, parks, police and defence. These public services require tax revenue.
This chapter has shed some light on how high the price of civilised society can be. Here we have seen that when the government imposes taxes on buyers or sellers of a good, however, society loses some of the benefits of market efficiency.
Taxes are costly to market participants not only because taxes transfer resources from those participants to the government, but also because they alter incentives and distort market outcome.
The cost of a subsidy.
Q(without subsidy) is normal equilibrium quantity
Q(with subsidy) is to the right of normal equilibrium
Cost of subsidy is area between price sellers receive, price buyers pay, Q(with subsidy) intersection of D and Q(with subsidy) intersection of S.
Quantity sold = length of subsidy square
Deadweight loss of a subsidy.
Triangle between Q(with subsidy) and old equilibrium is deadweight loss.
Remaining subsidy cost area and area between Demand and sully curves (to the right of former Equilibrium) is consumer and producer surplus. The consumer producer surplus triangles overlap.
However, when calculating total surplus you must subtract the subsidy cost because it is a cost.
