Chapter 8 : Application: The Costs of Taxation
Which curve shifts depends on whether the tax is levied on sellers (the supply curve shifts) or buyers(the
demand curve shifts). A tax on a good, no matter what, causes the size of the market for the good to
How a Tax affects Market Participants
The benefit received by buyers in a market is measured by consumer surplus – the amount buyers are
willing to pay for the good minus the amount they actually pay for it.
The benefit received by sellers in a market is measured by producer surplus – the amount sellers receive
for the good minus their costs to produce, and sell the good.
To analyze how taxes affect economic well-being , we use tax revenue to measure the government’s
benefit from the tax. However, this benefit actually accrues not to government but to those on whom
the revenue is spent.
Welfare without a Tax
Without a tax, the price and quantity are found at the intersection of the supply and demand curves.
Welfare with a Tax
To compute total surplus with tax, we add consumer surplus, producer surplus, and tax revenue.
Changes in Welfare
Not surprisingly, the tax makes buyers and sellers worse off and the government better off.
The change in total welfare includes the change in consumer surplus (which is negative), the change in
producer surplus (which is also negative), and the change in tax revenue (which is positive). When we
add these three pieces together, we find that total surplus in the market falls by the area (C+E). Thus,
the loss to buyers and sellers from a tax exceed the revenue raised by the government. The fall in total
surplus that results when a tax (or some policy) distorts a market outcome is called the deadweight loss.
Deadweight loss – the fall in total surplus that results from a market distortion, such as a tax.
Thus, because taxes distort incentives, they cause markets to allocate resources inefficiently.
Basically a deadweight loss occurs because the market loses surplus that would have been there without
For example, Joe cleans Jane’s house each week for $100. The opportunity cost of Joe’s time is $80, and
the value of a clean house to Jane is $120. Thus, Joe and Jane each receive a $20 benefit from the deal.
The total surplus of $40 measures the gains from trade in this deal.
But, now suppose that the government levies a $50 tax on the providers of cleaning services. There is no
price that Jane ca