Application: The Costs of Taxation
• Recall that welfare economics is the study of how
the allocation of resources affects economic wellbeing.
• Buyers and sellers receive benefits from taking part in
the market (CS & PS).
• The competitive market equilibrium outcome maximizes
the total well-being of buyers and sellers.
Copyright © 2004 South-Western/Thomson Learning
THE DEADWEIGHT LOSS OF
TAXATION
• How do taxes affect the economic well-being of
market participants?
• When a tax is levied in a market….
• The price paid by buyers rises and the price
received by sellers falls.
Copyright © 2004 South-Western/Thomson Learning
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 of units
bought and sold falls below the amount that would
be bought and sold without a tax (equilibrium).
• The size of the market for the taxed good shrinks.
Copyright © 2004 South-Western/Thomson Learning
How a Tax Affects Market Participants
• The change in total welfare includes:
•
•
•
•
The change in consumer surplus and producer surplus
The tax revenue.
Loss in CS and PS exceeds the tax revenue raised.
This drop in net well-being to society is called
deadweight loss (DWL).
• DWL arises because buyers and sellers no longer realize some
of the gains from trade compared to the competitive market
equilibrium outcome (some units are no longer traded).
Copyright © 2004 South-Western/Thomson Learning
Figure 4 The Deadweight Loss
Price
Lost gains
from trade
PB
Supply
Size of tax
Price
without tax
PS
Cost to
sellers
Value to
buyers
0
Q2
Demand
Quantity
Q1
Reduction in quantity due to the tax
Copyright © 2004 South-Western
DETERMINANTS OF THE
DEADWEIGHT LOSS
• What determines whether the DWL and the tax
revenue from a tax are large or small?
• The amounts of DWL and tax revenue depend on how
much the quantity supplied and quantity demanded
respond to changes in the price.
• In other words, the amounts of DWL and tax revenue
depend on the price elasticities of supply and demand.
Copyright © 2004 South-Western/Thomson Learning
DETERMINANTS OF THE
DEADWEIGHT LOSS
• More elastic demand and supply results in…
• Larger decline in equilibrium quantity.
• Greater DWL.
• Smaller tax revenue.
Copyright © 2004 South-Western/Thomson Learning
Summary
• A tax on a good reduces the well-being of buyers
and sellers of the good.
• The reduction in consumer surplus and producer
surplus usually exceeds the tax revenue raised.
• This drop in net well-being is referred to as the
deadweight loss (DWL) of the tax.
Copyright © 2004 South-Western/Thomson Learning
Summary
• Taxes generally have a DWL because they cause
buyers to consume less and sellers to produce less.
• This change in behavior shrinks the size of the
market below the competitive market equilibrium
outcome which maximizes total well-being.
Copyright © 2004 South-Western/Thomson Learning
Summary
• DWL is the cost of raising revenue from taxing a
particular good or service (no free lunch).
• It is more efficient to raise revenue by taxing
markets with inelastic demand and/or supply.
• You should always ask: What does policy success
require and what does reality look like?
Copyright © 2004 South-Western/Thomson Learning