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DWL - Relation With Elasicity

DWL - Relation With Elasicity

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Published by: Silentt Wordss on Nov 05, 2012
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12/04/2012

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Relation between
Elasticity’s
and DWL (Regarding toGovernment Tax Policy)
A tax has a deadweight loss because it induces buyers and sellers to change theirbehavior. The tax raises the price paid by buyers, so they consume less. At the sametime, the tax lowers the price received by sellers, so they produce less. Because of thesechanges in behavior, the size of the market shrinks below the optimum. The
elasticity’s
 of supply and demand measure how much sellers and buyers respond to the changes inthe price and, therefore, determine how much the tax distorts the market outcome.Hence,
the greater the 
elasticity’s
of supply and demand, the greater the deadweight loss of a tax.
 
Elastic Demand of Good X(i)
 
Higher responsive to price, i.e., higher change in quantity demanded (i.e.,transaction)(ii)
 
Higher change in transaction means higher deadweight loss (DWL).(iii)
 
When Govt imposestax on buyers, they lower the quantity demandedsignificantly, andgreater DWLis created.(iv)
 
Hence, govt should not impose tax onbuyersof good X, or should think twicebefore imposing tax on them.
 
Inelastic Demand of Good X(i)
 
Lower responsive to price ,i.e., lower change in quantity demanded (i.e.,transaction)(ii)
 
Lower change in transaction means lower deadweight loss (DWL).(iii)
 
When Govt imposestax on buyers, theylowerthe quantity demanded (but not significantly), andsmaller DWLis created. (iv)
 
Hence, govt can imposetax on buyersof good X. (But, govt should also seeelasticity of supply).
 
Elastic Supply of Good X(i)
 
Higher responsive to price ,i.e., higher change in quantity supplied (i.e.,transaction).(ii)
 
Higher change in transaction means higher deadweight loss (DWL.)(iii)
 
When Govt imposestax on sellers, they lower the quantity suppliedsignificantly, andgreater DWLis created.(iv)
 
Hence, govt should not impose tax onsellersof good X, or should think twicebefore imposing tax on them.
 
 
Inelastic Supply of Good X(i)
 
Lower responsive to price ,i.e., lower change in quantity supplied (i.e.,transaction)(ii)
 
Lower change in transaction means lower deadweight loss (DWL).(iii)
 
When Govt imposestax on sellers, theywould not lowerthe quantity supplied significantly, andsmaller DWLis created.(iv)
 
Hence, govt can impose taxon sellers of good X. (But, govt should also seeelasticity of demand).
Tax Should be Imposed on Buyers or Sellers?
It does not matter whether a tax on a good is levied on buyers or sellers of the good. When a tax islevied on buyers, the demand curve shifts downwards by the size of the tax; when it is levied onsellers, the supply curve shifts upwards by that amount. In either case, when the tax is enacted,the price paid by buyers rises, and the price received by sellers falls. In the end, the elasticities ofsupply and demand determine how the tax burden is distributed between producers andconsumers. This distribution is the same, regardless of how it is levied.It can be illustrated by an example.
 
Suppose market demand for tires (in millions) is given by the equationQ
D
= 12 - P. Tires are supplied according to the market supply equation Q
S
= 2P.(i) Calculate equilibrium price and quantity.(ii) Calculate price and quantity at new equilibrium when tax of Rs 3 perunit is imposed onsellers. Also calculate burden of tax on buyers, andsellers.(iii) Calculate price and quantity at new equilibrium when tax of Rs 3 perunit is imposed onbuyers. Also calculate burden of tax on buyers, andsellers.Solution:(i)Without tax  Given that Q
D
= 12
 –
P
……(i)
 Q
S
= 2P …………(ii)
 Solving (i) and (ii), Q = 8 , and P = 4(ii)When tax Rs 3 is imposed on sellers,Demand function remains same, but supply curve shifts upwards by 3 units.From (ii), Q
S
= 2POr, P = Q
S
/2After imposing tax of Rs 3 per unit on sellers,New supply function is P
 –
3 = Q
S
 /2 …..(iii)
 Solving (i) and (iii), we get P = 6, and Q = 6Price paid by buyers = Rs 6 per unit (i.e., buyers pay Rs 2 more)Price received by sellers = Rs 6
 –
Rs 3 = Rs 3 (i.e., sellers receive Re 1 less)

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