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Taxes & Deadweight Loss. How Taxes, Subsidies and Externalities reduce efficiency. Chapter 8. TAXATION. It does not matter if a tax is levied on buyers or sellers The end result of a new tax is the same : Price paid by buyers ↑ Price received by sellers ↓
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Taxes & Deadweight Loss How Taxes, Subsidies and Externalities reduce efficiency Chapter 8
TAXATION • It does not matter if a tax is levied on buyersorsellers The end result of a new tax is the same: • Price paid by buyers ↑ • Price received by sellers ↓ • Quantity sold falls (the market shrinks!) • Total Welfare falls
Tax Wedge • A tax places a wedge between the price buyers pay & the price sellers receive • Because of this tax wedge, quantity sold falls below the natural market equilibrium (invisible hand) • Overall, Total Welfare declines as the market shrinks
S = MC Price buyers Size of tax (wedge) pay Price without tax Price sellers receive D = MB Quantity Quantity with tax without tax The Effects of a Tax Price price paid by consumers is higher price received by firms is lower. Who benefits? E1 And the quantity declines. Quantity 0
S = MC Price buyers Size of tax (T) pay Tax revenue (T × Q) Price sellers receive D = MB Quantity sold (Q) Quantity Quantity with tax without tax Gov’t Tax Revenue Price Gov’t tax revenue = Size of tax * quantity sold Quantity 0
A + B + C = Consumer Surplus (before tax) S = MC A Price buyers PB = pay B E1 maximizes Total Welfare C Price P1 = without tax E D Price sellers PS = receive F D = MB Producer Surplus = D + E + F (before tax) Q2 Q1 Total Welfare before Tax Price E1 0 QTY
Deadweight Loss • Deadweight loss- the fall in total surplus that results from a tax • underproduction and overproduction both lead to deadweight loss Taxes reduce production Therefore, with all taxes Society incurs a Deadweight Loss!
Area C + E is a complete loss to Society: (DEADWEIGHT LOSS) S = MC A Price buyers PB = pay B C Price P1 = without tax E D Price sellers PS = receive F D = MB B + D = Tax Revenue Q2 Q1 Total Welfare After Tax Price Quantity 0
Total Welfare withTax • Total Welfare (Surplus) include the sum of: • Adjusted consumer surplus • Adjusted producer surplus • Increase in tax revenue • The loss to buyers & sellers exceed the revenue raised by the government • Therefore, unless you are correcting an externality, when taxes increase, Total Surplusfalls
S = MC A P2 B C P1 E D P3 F D = MB 50 100 Handout: Taxes & Deadweight Loss Price $50 $40, $30, $22, $14 Quantity 0
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