principles of microeconomics & principles of macroeconomics: ch.8 first canadian edition chapter...

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition

Chapter 8

The Costs of Taxation

Copyright (c) 1999 Harcourt Brace & Company, Canada, Ltd. All rights reserved.


Market Efficiency: Three observations

Free markets allocate the supply of goods to the buyers who value them most highly.

Free markets allocate the demand for goods to the sellers who can produce them at least cost.

Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.



A tax places a wedge between the price buyers pay and the price sellers receive.

Tax!



A tax places a wedge between the price buyers pay and the price sellers receive.

A tax results in a Deadweight Loss to society and the economy

Tax! Loss!


Deadweight Loss of Taxation: Graphical

$.50

1000

Demand

Supply



$.50

1000

Demand

Supply

$.60

$.40

800

$.20 tax imposed


Deadweight Loss of Taxation: Example

The twenty cent tax results in new prices to consumers and producers:– Consumers pay $0.60

– Sellers receive $0.40 The Tax Revenue from the imposed tax

is = $160 i.e. [($0.60-$0.40) x 800]



$.50

1000

Demand

Supply

$.60

$.40

800

Tax Revenue


Deadweight Loss of Taxation

The tax places a wedge between the price buyers pay and the price sellers receive. The higher price to buyers and the lower price to sellers results in a lower quantity demanded and quantity supplied.

The loss in quantity demanded and the quantity supplied is 200 units (1000 - 800).



$.50

1000

Demand

Supply

$.60

$.40

800

DeadweightLoss = $20


Deadweight Loss of Taxation, example

The deadweight loss of 200 units do no one any good– The value of the loss to society due to

the twenty cent tax is = $20 ($500 - $480)

Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.


Determinants of Deadweight Loss

The magnitude of the Deadweight Loss depends upon how large a decline in market exchange occurs as a result of the tax.

The size in the decline in market exchange depends upon how sensitive consumers and producers are to changes in prices: Elasticity Concept.



The more elastic demand and supply are, the greater will be the

decline in equilibrium quantity and the greater the

Deadweight Loss.


More Elastic Demand and Supply

S0

D0

QE

PE



S0

D0

QE

PE

S2

Amount of Tax



S0

D0

QE

PE

S2

Amount of Tax

Q2

P2



S0

D0

QE

PE

S2

Amount of Tax

Q2

P2

DeadweightLoss!



A tax has a deadweight loss because it induces buyers and sellers to change their behaviour.– Higher prices cause buyers to buy less.

– Lower prices received causes sellers to offer less.

The size of the market shrinks below the optimum.


Less Elastic Demand and Supply

S0

D0

QE

PE



S0

D0

QE

PE

S2

P2

Q2

Amount of Tax



S0

D0

QE

PE

S2

P2

Q2

Amount of Tax

DeadweightLoss!


Deadweight Loss and Tax Revenue The deadweight loss of a tax rises

even more rapidly than the size of the tax. – It is related to the area of a triangle. If we

double the tax, the size of the triangle increases four times.

With each increase in the tax rate, tax revenues will rise slowly, reach a maximum, and decline.


The Costs of Taxation: Conclusion

When a tax is imposed on a good, the tax reduces consumer and producer surplus by an amount that is greater than the tax revenue generated.

The difference between the decrease in total consumer and producer surplus and the tax revenue generated is referred to as the Deadweight Loss of a tax.


The Costs of Taxation: Conclusion

As the tax gets larger, the deadweight loss increases more than proportionate to the tax increase.

With the increase in the tax rate, the percentage decrease in market equilibrium quantity becomes greater. Tax revenues begin to decrease.

principles of microeconomics & principles of macroeconomics: ch.8 first canadian edition chapter...

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