APPLICATIONS: DEADWEIGHT
LOSS
ETP Economics 101
DEADWEIGHT LOSS

Changes in Welfare

A deadweight loss is the fall in total surplus that
results from a market distortion, such as government
regulations on prices and tax.
Price ($ per month)
RENT CONTROL: EQUILIBRIUM
1100
b
1000
900
0
supply
equilibrium
excess demand
290
300
demand
310
Quantity (Thousand units a month)
Rent Control: Surpluses
Price ($ per month)
Consumer surplus gain = cfeg
Consumer surplus loss = dgb
Producer surplus loss = cfeg +
geb
Deadweight loss=dgb+geb
d
1100
1000 c
900
f
b
g
supply
e
demand
0
290
300
310
Quantity (Thousand units a month)
Wage ($ per hour)
MINIMUM WAGE: EQUILIBRIUM
a
excess supply
supply
4.20
b
4.00
equilibrium
c
0
demand
8
10
11
Quantity (Billion worker-hours a week)
Wage ($ per hour)
Minimum Wage: Surpluses
seller (employee) surplus gain =
fdge
seller (employee) surplus loss =
ghb
buyer (employer) surplus loss =
fdge + egb
Deadweight loss=ghb+egb
a
4.20
4.00
f
d
supply
e
b
g
h
c
0
demand
8
10
11
Quantity (Billion worker-hours a week)
FIGURE 1 THE EFFECTS OF A TAX
Price
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
TAX WEDGE
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.

FIGURE 2 TAX REVENUE
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
revenue
(T × Q)
Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
FIGURE 3 HOW A TAX EFFECTS WELFARE
Price
Price
buyers = PB
pay
Supply
A
B
C
Price
without tax = P1
Price
sellers = PS
receive
E
D
F
Demand
0
Q2
Q1
Quantity
Copyright © 2004 South-Western
DETERMINANTS 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 elasticities of
supply and demand.

DETERMINANTS 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.

FIGURE 5 TAX DISTORTIONS AND ELASTICITIES
(a) Inelastic Supply
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
Copyright © 2004 South-Western
FIGURE 5 TAX DISTORTIONS AND ELASTICITIES
(b) Elastic Supply
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax
Supply
Demand
0
Quantity
Copyright © 2004 South-Western
FIGURE 5 TAX DISTORTIONS AND ELASTICITIES
(c) Inelastic Demand
Price
Supply
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0
Quantity
Copyright © 2004 South-Western
FIGURE 5 TAX DISTORTIONS AND ELASTICITIES
(d) Elastic Demand
Price
Supply
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
0
Quantity
Copyright © 2004 South-Western
DEADWEIGHT LOSS AND TAX RATE

With each increase in the tax rate, the
deadweight loss of the tax rises even more
rapidly than the size of the tax.
TAX REVENUE AND TAX RATE
For the small tax, tax revenue is small.
 As the size of the tax rises, tax revenue grows.
 But as the size of the tax continues to rise, tax
revenue falls because the higher tax reduces the
size of the market.

FIGURE 6 DEADWEIGHT LOSS AND TAX REVENUE FROM
THREE TAXES OF DIFFERENT SIZES
(a) Small Tax
Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
FIGURE 6 DEADWEIGHT LOSS AND TAX REVENUE FROM
THREE TAXES OF DIFFERENT SIZES
(b) Medium Tax
Price
Deadweight
loss
PB
Supply
Tax revenue
PS
0
Demand
Q2
Q1 Quantity
Copyright © 2004 South-Western
FIGURE 6 DEADWEIGHT LOSS AND TAX REVENUE FROM
THREE TAXES OF DIFFERENT SIZES
(c) Large Tax
Price
PB
Tax revenue
Deadweight
loss
Supply
Demand
PS
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
FIGURE 7 HOW DEADWEIGHT LOSS AND TAX REVENUE VARY
WITH THE SIZE OF A TAX
Deadweight
Loss
0
Tax Size
Copyright © 2004 South-Western
FIGURE 7 HOW DEADWEIGHT LOSS AND TAX REVENUE VARY
WITH THE SIZE OF A TAX
Tax
Revenue
0
Tax Size
Copyright © 2004 South-Western
LAFFER CURVE AND SUPPLY-SIDE
ECONOMICS
The Laffer curve depicts the relationship between
tax rates and tax revenue.
 Supply-side economics refers to the views of
Reagan and Laffer who proposed that a tax cut
would induce more people to work and thereby
have the potential to increase tax revenues.
