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Midterm

EC120 Study Guide - Midterm Guide: Deadweight Loss, Market Distortion


Department
Economics
Course Code
EC120
Professor
All
Study Guide
Midterm

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Chapter 8 – Application: The Costs of Taxation
Buyers and sellers are worse off when a good is taxed; a tax raises the price a buyer pays
and lowers the price a seller receives
Governments can sometimes impose taxes to achieve a more efficient outcome when
markets do not function properly, as in the case of “corrective taxes”
Taxes also help distribute income equally
The Deadweight Loss of Taxation
When are taxes levied on buyers, the demand curve shifts downwards by the size of the
tax; when it is levied on sellers, the supply curve shifts upward by that amount
Buyers and sellers share the burden of tax
A tax on a good causes the size of the market for the good to shrink
How a Tax Affects Market Participants
The benefit received by buyers in the market is measured by consumer surplus
Tax revenue = (PB-PS)*QT
CS = APS = F Tax revenue = CS+PS+B+D DWL = C+E

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The losses to buyers and sellers from attacks exceed the revenue is by the government.
The difference is the deadweight loss
Deadweight Losses and the Gains from Trade
Taxes cause deadweight losses because they prevent buyers and sellers from realizing
some of the gains from trade
The deadweight loss is the surplus lost because the tax discourages mutually
advantageous trades
The Determinants of the Deadweight Loss
Price elasticity affects the size of the deadweight loss
More elastic = more deadweight loss
Deadweight Loss and Tax Revenue as Taxes Vary
Taxes rarely stay the same for a long period of time
As tax rates increase, the deadweight loss increases
As tax rate increases tax revenue increases first, then decreases diminishing marginal
return
Governments tax revenue equals the size of the tax times the amount of the good sold
Laffer curve: shows the relationship between the size of the tax and the tax revenue
A tax-cut is more likely to raise tax revenue if the cut applies to those taxpayers facing
the highest tax rate
Economists disagree about these issues because there is no consensus about the size of
the relevant elasticities
How much revenue the government games or loses from a tax change cannot be
computed just by looking at tax rate. It all depends on how the tax change affects people’s
behavior

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Chapter 9 – Application: International Trade
The Determinants of Trade
The Equilibrium without Trade
If the government allowed Isolandians to import and export textiles, what would happen
to the price of textiles and the quantity of textiles sold in the domestic textile market?
o Once trade is allowed, the domestic price will be driven to equal the prevailing
price around the world
Who would gain from free trade in textiles and who would lose, and would the gains
exceed the losses?
o If the price rises, producers gain and consumers lose. If the price falls,
consumers gain, and producers lose
Should a tariff or an import quote be a part of the new trade policy?
oA tariff has deadweight losses: the revenue raised would be smaller than the losses
to the buyers and sellers. And ideal situation would be to allow trade without a
tariff or import quotas
The World Price and Comparative Advantage
To see whether a country will import or export, compare the world price in the market
World price: the price of the good that prevails in the world market for that good
World price is higher than domestic price = export
World price is less than domestic price = import
Comparing the world price and domestic price indicates whether a country has a
comparative advantage or not
Domestic price reflects the opportunity cost
The Winners and Losers from Trade
Small economy = price takers = they take the price of the market as given
Canadian economy accounts for 2% of the world GDP
The Gains and Losses of an Exporting Country – works like a surplus
World price can be seen as a demand curve (a competitor is the rest of the world)
perfectly elastic because it can sell as many quantities of products at the world price
Trade forces the domestic price to rise to the world price
When a country allows trade and becomes an exporter of a good, domestic producers of
the good are better off and domestic consumers of the good are worse off
Trade raises the economic well being of a nation in the sense that the gains of the winners
exceed the losses of the losers
The Gains and Losses of an Importing Country – works like a shortage
When a country allows trade and becomes an importer of a good, domestic consumers of
the good are better off and domestic producers of the good are worse off
Trade raises the economic well being of a nation in the sense that the gains of the winners
exceed the losses of the losers
Trade can make everyone better off
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