APPLICATION: THE COSTS OF
Problems and Applications
1. a. Figure 3 illustrates the market for pizza. The equilibr1um price is P , the equilibrium
quantity is1Q , consumer surplus is area A+B+C, and producer surplus is area D+E+F.
There is no deadweight loss, as all the potential gains from trade are realized; total
surplus is the entire area between the demand and supply curvesA+B+C+D+E+F.
b. With a $1 tax on each pizza sold, the price paid bB buyers, P , is now higher than the
price received by sellSrs, P ,BwheSe P = P + $1. The quantity d2clines to Q , consumer
surplus is area A, producer surplus is area F, government revenue is area B+D, and
deadweight loss is area C+E. Consumer surplus declines by B+C, producer surplus
declines by D+E, government revenue increases by B+D, and deadweight loss increases
c. If the tax were removed and consumers and producers voluntarily transferred B+D to
the government to make up for the lost tax revenue, then everyone would be better off
than without the tax. The equilibrium quantity would be Q , as in the case without the
tax, and the equilibrium price wou1d be P . Consumer surplus would be A+C, because
consumers get surplus of A+B+C, then voluntarily transfer B to the government.
Producer surplus would be E+F, since producers get surplus of D+E+F, then voluntarily
transfer D to the government. Both consumers and producers are better off than the
case when the tax was imposed. If consumers and producers gave a little bit more than
149 150 ✦ Chapter 8 /Application: The Costs of Taxation
B+D to the government, then all three parties, including the government, would be
better off. This illustrates the inefficiency of taxation. Chapter 8 /Application: The Costs of Taxation ✦ 151
2. a. The increase in demand increases the market price, as Figure 4 shows. Since the supply
of land is assumed inelastic, the revenue to landlords increases.
Quantity of Land
b. A tax on land reduces the demand. Since the supply of land is inelastic, the landlords
have to decrease the price exactly by the amount of the tax in order to maintain the
quantity demanded at the same level as the fixed amount of land supplied. The entire
burden of the tax is, thus, born by the landlords. .
c. The deadweight loss is zero, because the equilibrium quantity does not change.
d. George’s land tax may not apply to real estate because the supply of real estate is not
perfectly inelastic: more houses can be built when demand increases. Another difference
is that real estate requires maintainance and upgrading, as opposed to unimproved land.
3. a. The statement, "A tax that has no deadweight loss cannot raise any revenue for the
government," is incorrect. An example is the case of a tax when either supply or
demand is perfectly inelastic. The tax has neither an effect on quantity nor any
deadweight loss, but it does raise revenue.
b. The statement, "A tax that raises no revenue for the government cannot have any
deadweight loss," is incorrect. An example is the case of a 100 percent tax imposed on
sellers. With a 100 percent tax on their sales of the good, sellers won't supply any of the
good, so the tax will raise no revenue. Yet the tax has a large deadweight loss, since it
reduces the quantity sold to zero. 152 ✦ Chapter 8 /Application: The Costs of Taxation
4. a. With very elastic supply and very inelastic demand, the burden of the tax on rubber
bands will be borne largely by buyers. As Figure 5 shows, consumer surplus declines
considerably, by area A+B, but producer surplus doesn't fall much at all, just by area
b. With very inelastic supply and very elastic demand, the burden of the tax on rubber
bands will be borne largely by sellers. As Figure 6 shows, consumer surplus does not
decline much, just by area A+B, while producer surplus falls substantially, by area C+D.
Compared to part (a), producers bear much more of the burden of the tax, and
consumers bear much less.
Figure 6 Chapter 8 /Application: The Costs of Taxation ✦ 153
5. a. The deadweight loss from a tax on heating oil is likely to be greater in the fifth year after
it is imposed rather than the first year. In the first year, the elasticity of demand is fairly
low, as people who own oil heaters are not likely to get rid of them right away. But over
time, they may switch to other energy sources and people buying new heaters for their
homes will more likely choose gas or electric, so the tax will have a greater impact on
b. The tax revenue is likely to be higher in the first year after it is imposed than in the fifth
year. In the first year, demand is more inelastic, so the quantity does not decline as
much and tax revenue is relatively high. As time passes and more people substitute
away from oil, the equilibrium quantity declines, as does tax revenue.
6. Since the demand for food is inelastic, a tax on food is a good way to raise revenue because it
does not lead to much of a deadweight loss; thus taxing food is less inefficient than taxing other
things. But it is not a good way to raise revenue from an equity point of view, since poorer
people spend a higher proportion of their income on food, so the tax would hit them harder than
it would hit wealthier people.
7. a. This tax has such a high rate that it is not likely to raise much revenue. Because of the
high tax rate, the equilibrium quantity in the market is likely to be at or near zero.
b. Senator Moynihan's goal was probably to ban the use of hollow-tipped bullets. In this
case, a tax is as effective as an outright ban.
8. a. Figure 7 illustrates the market for socks and the effects of the tax. Without a tax, the