Chapter 8: ECON 2

the reduction in consumer and producer surplus is greater than the tax revenue. The fall in total surplus that results when a tax (or some other policy) distorts a market outcome is called a deadweight loss. Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade. Therefore, a tax on a good has deadweight loss if the reduction in consumer and producer surplus is greater than the tax revenue. See Section: Deadweight Losses and the Gains from Trade.

$0, -$10, $0 In this case, the entire tax is passed to Sofia, the consumer. Therefore, there is no change in producer surplus, because the price received by Sam remains the same, but there is a decrease of $10 in consumer surplus because Sofia now pays $10 more than before. Since no mutually beneficial transactions are lost as a result of the tax, all of the decrease in consumer surplus goes to government revenue. Therefore, overall surplus remains the same, and deadweight loss is zero. See Section: How a Tax Affects Market Participants.

increases by more than 50 percent. If demand is downward sloping and supply is upward sloping, the deadweight loss of a tax rises even more rapidly than the size of the tax. This occurs because the deadweight loss is the area of a triangle, and the area of a triangle depends on the square of its size. If you double the size of a tax, for instance, the base and height of the triangle double, so the deadweight loss rises by a factor of 4. In this case, if the size of a tax increases by 50 percent, the deadweight loss of the tax increases by more than 50 percent. See Section: Deadweight Loss and Tax Revenue as Taxes Vary.

increases by less than 50 percent and may even decline. The government's tax revenue is the size of the tax times the amount of the good sold. Graphically, tax revenue equals the area of the rectangle formed by the tax wedge between the supply and demand curves. Recall that the area of a rectangle is width times length; in this case the width is the amount of the tax and the length is the quantity sold. When a tax increases from 10 cents to 15 cents per pound, this means the width of the rectangle increases by 50 percent. However, because demand is downward sloping and supply is upward sloping, the length of this rectangle also decreases. Therefore, the overall area of the rectangle increases by less than 50 percent and may even decline if the decrease in length more than offsets the increase in width. See Section: Deadweight Loss and Tax Revenue as Taxes Vary.

government's tax revenue. The Laffer curve shows the relationship between the tax on a good and the amount of government tax revenue received. In some instances, as the size of a tax increases, tax revenue grows. But as the size of the tax increases further, tax revenue falls because the higher tax drastically reduces the size of the market. See Section: Deadweight Loss and Tax Revenue as Taxes Vary.

small, small A tax has a deadweight loss because it induces buyers and sellers to change their behavior. 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 behavior, 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. So the policymaker should look for goods with as little elasticity as possible, in both supply and demand. See Section: The Determinants of the Deadweight Loss.

Market B

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When demand is relatively elastic, the deadweight loss of a tax is larger than when demand is relatively inelastic.

unscrupulous people to take part in the underground economy.

equilibrium quantity of the good always decreases.