PowerPoint Presentations for
Principles of Microeconomics
Sixth Canadian Edition
by Mankiw/Kneebone/McKenzie
Adapted for the
Sixth Canadian Edition by
Marc Prud’homme
University of Ottawa
APPLICATION:
THE COSTS OF
TAXATION
Chapter 8
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APPLICATION: THE COSTS OF TAXATION
 To understand fully how taxes affect
economic well-being, we must compare the
reduced welfare of buyers and sellers to the
amount of revenue the government raises.
 The tools of consumer and producer surplus
allow us to make this comparison.
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THE DEADWEIGHT LOSS OF TAXATION
 When a tax is levied on buyers, the demand curve shifts
downward by the size of the tax.
 When it is levied on sellers, the supply curve shifts upward
by that amount.
 In either case, when the tax is enacted, the price paid by
buyers rises and the price received by sellers falls.
 In the end, buyers and sellers share the burden of the tax,
regardless of how it is levied.
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FIGURE 8.1:
The Effects of a Tax
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How a Tax Affects Market Participants
 Let’s use the tools of welfare economics to measure
the gains and losses from a tax on a good.
 To do this, we must take into account how the tax
affects buyers, sellers, and the government.
 The benefit received by buyers in a market is
measured by consumer surplus.
 The benefit received by sellers in a market is
measured by producer surplus.
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How a Tax Affects Market Participants
 What about the third interested party, the
government?
 If T is the size of the tax and Q is the quantity
of the good sold, then the government gets
total tax revenue of T x Q.
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FIGURE 8.2:
Tax Revenue
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How a Tax Affects Market Participants
Welfare without a Tax
 To see how a tax affects welfare, we begin by
considering welfare before the government has
imposed a tax.
 Without a tax, the price and quantity are found
at the intersection of the supply and demand
curves.
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FIGURE 8.3:
How a Tax Affects Welfare
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FIGURE 8.3 (continued)
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How a Tax Affects Market Participants
Welfare with a Tax
 The price paid by buyers rises from P1 to PB, so consumer
surplus now equals only area A.
 The price received by sellers falls from P1 to PS, so
producer surplus now equals only area F.
 The quantity sold falls from Q1 to Q2, and the government
collects tax revenue equal to the area B + D.
 Total surplus with the tax, we add consumer surplus,
producer surplus, and tax revenue.
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How a Tax Affects Market Participants
Changes in Welfare
 We can now see the effects of the tax by
comparing welfare before and after the
tax is enacted.
 The change in total welfare includes the
change in consumer surplus (which is
negative), the change in producer surplus
(which is also negative), and the change
in tax revenue (which is positive).
Thinkstock
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How a Tax Affects Market Participants
Changes in Welfare (continued)
 When we add these three pieces together, we find that
total surplus in the market falls by the area C + E.
 Thus, the losses to buyers and sellers from a tax exceed
the revenue raised by the government.
 The fall in total surplus that results when a tax distorts a
market outcome is called the deadweight loss.
 The area C + E measures the size of the deadweight loss.
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Deadweight Losses and the Gains from Trade
 Taxes cause deadweight losses because they
prevent buyers and sellers from realizing some
of the gains from trade.
 The area of the triangle between the supply
and demand curves (area C + E in Figure 8.3)
measures these losses.
 This loss can be seen most easily in Figure 8.4.
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FIGURE 8.4:
The Deadweight Loss
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QuickQuiz
Draw the supply and demand curves for
cookies. If the government imposes a tax on
cookies, show what happens to the quantity
sold, the price paid by buyers, and the price
paid by sellers.
In your diagram, show the deadweight loss
from the tax.
Explain the meaning of the deadweight loss.
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Active Learning
Analysis of a Tax
The market for
airplane tickets
P
A. Compute
CS, PS, and total
surplus without a tax.
$400
B. If $100 tax per ticket,
300
compute CS, PS,
tax revenue, total
surplus, and DWL.
350
S
250
200
150
D
100
50
Q
0
0
25
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50
75 100 125
18
Active Learning
Answers to A
P
The market for
airplane tickets
$ 400
CS
= ½ x $200 x 100
= $10,000
PS
= ½ x $200 x 100
= $10,000
Total surplus
= $10,000 + $10,000
= $20,000
350
300
S
250
P=
200
150
100
D
50
Q
0
0
25
50
75 100 125
19
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Active Learning
Answers to B
CS
= ½ x $150 x 75
= $5,625
PS = $5,625
P
A $100 tax on
airplane tickets
$ 400
350
300
S
PB = 250
200
Tax revenue
= $100 x 75
= $7,500
PS = 150
Total surplus
= $18,750
0
100
D
50
Q
0
25
50
75 100 125
DWL = $1,250
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THE DETERMINANTS OF THE
DEADWEIGHT LOSS
 What determines whether the deadweight
loss from a tax is large or small?
 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.
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FIGURE 8.5:
Tax Distortions and Elasticities
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FIGURE 8.5 (continued)
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QuickQuiz
The demand for beer is more elastic than the
demand for milk.
Would a tax on beer or a tax on milk have a
larger deadweight loss?
Why?
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DEADWEIGHT LOSS AND
TAX REVENUE AS TAXES VARY
 What happens to the deadweight loss and tax
revenue when the size of a tax changes?
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FIGURE 8.6:
Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
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FIGURE 8.6 (continued)
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QuickQuiz
If the government doubles the tax on gasoline,
can you be sure that revenue from the
gasoline tax will rise?
Can you be sure that the deadweight loss
from the gasoline tax will rise?
Explain.
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Classroom Activity
Labour Taxes
1. Assume you are full-time workers earning $10 per
hour, $80 per day, $400 per week, $20,000 per year?
2. Would you quit your job or keep working if the tax
rate was 10 percent, 20 percent, 30 percent, … (up
to 100 percent)?
3. In your opinion, what is the “best” tax rate is?
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THE END
Chapter 8
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