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Bridget O' Shaughnessy

Unit 4: Markets and Economic Welfare - Objective 3: Deadweight Loss of Taxation 4.3.1 How Taxes Affect the Welfare of Producers and Consumers The burden of taxes is shared by both consumers and sellers. As stated in the textbook (p. 166), a tax places a wedge between the price consumers pay and the price sellers receive. Due to this tax wedge, the quantity of the product sold falls below the level without the tax. This is illustrated in Figure 8.3 on page 168, reproduced here as Figure 4.2. As seen in the figure, the quantity of supply with tax2(Q ) is less than the quantity without the tax (Q1). The tax amount is the equal toBP – A . As shown in the figure, this tax creates a deadweight loss of shaded area C + E, because this area represents the fall in total surplus after the imposition of the tax. The source of this deadweight loss is unrealized gains from trade due to the tax. After the tax is imposed, only 2 units are traded, not the higher amount 1 traded prior to the tax imposition. This generates a loss of consumer surplus shown by Area C + B, and a loss of producer surplus shown by Area E + D. Part of the loss of consumer and producer surplus is gained by the government in the form of tax revenue (Area B +D). The remaining part, Area C + E, represents the loss of total surplus or the deadweight loss to society. Thedeadweight loss is created because the loss of consumer and producer surplus from a taxexceeds the revenue raised by the government. 4.4.1 Will the Deadweight Loss be Large or Small? The concept of elasticity measures the responsiveness of the quantity supplied and the quantity demanded due to the change in price after the tax is imposed. So, the more elastic(responsive) the demand or supply, the greater the behavioral change in terms of quantity consumed and produced, leading to a larger deadweight loss. This is seen in Figure 4.3 below (reproduced from textbook Figure 8.5, p. 171): Figure 4.3: Tax distortions and elasticities From Mankiw/Kneebone/McKenzie/Rowe. Principles of Microeconomics © 2008 Nelson Education Ltd. Reproduced by permission. As seen in the figure, the more elastic (flatter) demand or supply is, the larger the size of the deadweight loss. When demand is relatively elastic, the deadweight loss of a tax is large. When demand is relatively inelastic, the deadweight loss of a tax is small. When supply is relatively elastic, the deadweight loss of a tax is large. When supply is relatively inelastic, the deadweight loss of a tax is small. The textbook (p. 106) told us that the price elasticity of supply measures how much the quantity supplied responds to changes in price. Panel (a) of Figure 4.3 above shows a relatively inelastic supply, which implies that the quantity supplied responds only sli
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