Transcript Applications: Deadweight Loss

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 REGULATION
Case 1: Rent control
 Case 2: Minimum wage

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)
The Deadweight Loss of
Taxation

Tax on a good

Levied on buyers
• Demand curve shifts downward by the
size of tax

Levied on sellers
• Supply curve shifts upward by the size of
tax

Same outcome: price wedge
• Price paid by buyers – rises
• Price received by sellers – falls
• Lower quantity sold
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The Deadweight Loss of
Taxation

Tax burden
Distributed between producers and
consumers
 Determined by elasticities of supply
and demand


Market for the good - smaller
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The effects of a tax
Price
Supply
Price buyers pay
Price without tax
Size
of
tax
Price sellers receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
A tax on a good places a wedge between the price that buyers pay and the
price that sellers receive. The quantity of the good sold falls.
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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.

THE DEADWEIGHT LOSS OF TAXATION
How a tax affects market participants
 Gains and losses from a tax on a good

Tax times quantity sold
 Public benefit from the tax

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Buyers: consumer surplus
 Sellers: producer surplus
 Government: total tax revenue

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
HOW A TAX AFFECTS WELFARE
Price
Price
buyers
pay =PB
Price
without=P1
tax
Price =PS
sellers
receive
Supply
A
B
C
E
D
F
0
Consumer Surplus
Producer Surplus
Tax Revenue
Total Surplus
Demand
Q2
Q1
A tax on a good reduces
consumer surplus (by the
area B + C) and producer
surplus
(by the area D + E).
Because the fall in
producer and consumer
surplus exceeds tax
revenue (area B + D), the
tax is said to impose a
deadweight loss (area C +
E).
Quantity
Without Tax
With Tax
Change
A+B+C
D+E+F
None
A+B+C+D+E+F
A
F
B+D
A+B+D+F
-(B+C)
-(D+E)
+(B+D)
-(C+E)
The area C + E
shows the fall in total
surplus and is the
deadweight loss of
the tax
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THE DEADWEIGHT LOSS OF TAXATION



Deadweight loss


Exceed the revenue raised by the government
Fall in total surplus that results from a market
distortion, such as a tax
Taxes distort incentives

Markets allocate resources inefficiently
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Losses of surplus to buyers and sellers from a tax
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.
THE DEADWEIGHT LOSS DEBATE

40% labor tax - Small or large deadweight loss?

Labor supply - fairly inelastic
Almost vertical
 Tax on labor - small deadweight loss


Labor supply - more elastic

Tax on labor – greater deadweight loss
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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
DEADWEIGHT LOSS & TAX REVENUE AS
TAXES VARY


Deadweight loss increases


Even more rapidly than the size of the tax
Tax revenue
Increases initially
 Then decreases
 Higher tax – drastically reduces the size of the market

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As the tax increases
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.

THE LAFFER CURVE AND SUPPLYSIDE ECONOMICS

1974, economist Arthur Laffer
Laffer curve
 Supply-side economics
 Tax rates were so high



Reducing them would actually raise tax revenue
Ronald Reagan - ran for president in 1980

From experience in film industry
High tax rates - caused less work
 Low tax rates - caused more work

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THE LAFFER CURVE AND SUPPLYSIDE ECONOMICS

Ronald Reagan - ran for president in 1980

Argument
Taxes were so high that they were discouraging hard work
 Lower taxes would give people the proper incentive to work

Raise economic well-being
 Perhaps increase tax revenue

Economists continue to debate Laffer’s argument
 General lesson:

Change in tax revenue from a tax change
 Depends on how the tax change affects people’s behavior

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