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Chapter 8

Chapter 8.docx

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University of Ottawa
David Gray

Chapter 8: Application- the costs of taxation - *Midterm Re-evaluation (go to website, compare your answer to the solutions sheet for improving your grade) Basic objective - Given the tools of welfare economics dealt with in chapter 7 (i.e. consumer surplus, producer surplus, and total surplus), how are they affected by the imposition of a tax? - Difficult material to follow Before – after equilibria: - Suppose that a per unit excise tax is imposed on sellers - S shifts upward and to the left by the full amount of the tax, called T - New equilibrium P higher, new equilibrium Q lower - Figure 8.2 (See Figure 8-2: Tax revenue) - Note that tax revenue = T * new Q - Next step is to determine who wins and who loses, and by how much - Before the tax, TS = CS + PS o In figure 8-3, CS = areas A + B + C o In figure 8-3, PS = areas D + E + F (See Table 8-1: Changes in Welfare from a Tax, See Figure 8-3: How a Tax Affects Welfare) After the tax, TS = CS + PS + Tax Revenue - In figure 8-3, CS = A (they lose) - In figure 8-3, PS = F (they lose) - In Figure 8-3, Tax Revenue = B + D (government wins) Deadweight loss: - deadweight loss = NET loss in total surplus after the tax has been implemented - The NET effect on total surplus is always negative, as the gains realized by the government are outweighed by the losses of both demanders and suppliers - Major point: taxes do not materialize out of thin air Why a loss in welfare? o Lower equilibrium quantity o In chapter 7, it was shown that the free market equilibrium Q was efficient, but now we are producing at a lower quantity o In other words, taxes choke off private sector activity that would otherwise occur - This is not an argument against taxation, because taxes are required in order to finance government services - It is an argument that tax revenue is NOT FREE – that is does have consequences on economic activity o Depending on the type of tax, it is estimated that perhaps every $1.00 of revenue raised causes a decline of $1.40 of welfare in the private sector o This is true even when the taxes are paid by the ‘rich’ - Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from exchange o Demonstrated in Figure 8-4 - In the range from Q1 to Q2, consumers’ valuation (height of D curve) exceeds suppliers’ opportunity cost of producing (height of S curve), so a mutually beneficial trade does not occur (See Figure 8-4: The Deadweight Loss) Possible MCQ Question: what is the source of deadweight losses (the taxes impos
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