ECONOMICS 11:

THE WELFARE COSTS OF TAXATION

TF: EDDY SANTOS
RECALL:
s
P s

¡ A tax generally… T
Buyer y
¡ Drives a wedge between the price buyers pay and the price sellers receive i i
¡ Raises the price buyers pay and lowers the price sellers receive
p i
Pseller I l
¡ Reduces the quantity bought and sold l t
¡ These effects are the same QnewOT Q
QnewLOT
¡ Whether the tax is imposed on buyers or sellers (economic incidence of taxation)

I
depends on the 2

elasticies
relative demand
RECALL:
P s

¡ A subsidy generally… Psellers

T
¡ Drives a wedge between the price buyers pay and the price sellers receive p
¡ Lowers the price buyers pay and increases the price sellers receive of
¡ Increases the quantity bought and sold
Pbuy i
I i
¡ These effects are the same Q Qnew Q
¡ Whether the subsidy is imposed on buyers or sellers Qnew Q

3
TWO EQUIVALENT WAYS OF TAXATION

¡ Recall:
S
¡ A legal tax on buyers is equivalent
to a legal tax on sellers. That is, the

I
economic effect of both is the
same.
v
an perspective
from
economic

D
4
 WELFARE EFFECT OF TAXATION
S
Before After Change

Btc
Consumer
Cs At Btc A
DTE
producer Eff F

g
yoyAL At Btl At Bt CTE
Revenue P Q 5

SURPLUS 1 DtEff D F V ight T Q

Deadwer Tax revenue
loss
WELFARE EFFECT OF SUBSIDIES
Sure that new TS hold TS Total
y
¡ Remember, subsidies have the ”opposite” effect as taxes
p gov't revenue
S
Qnew
(on a price and quantity point-of-view)
Subsidy S
Before After Change A
BtDDEt6 Fellers 1

t
ATB tf 6 C un
Cs B

is fi
l D
f
6

T AtB
surplus DTE Qnew Q
 D

THE SIZE OF THE DEADWEIGHT LOSS

¡ In general, the deadweight loss scales

proportionally with both the price elasticities More price elastic
of supply and demand. That is, the more price
elastic either the supply and demand of a good is, then more likely to
the larger the deadweight loss. (What is the
the
intuition?)
drop out of
¡ The deadweight loss also scales proportionally market when
with the size of the tax. However, the deadweight
loss, in general, increases in a more-than-linear fashion prices go up
(e.g. doubling the tax leads to a greater than double
the deadweight loss).

7
THE SIZE OF THE DEADWEIGHT LOSS

P dependentamsirits
¡ In general, the deadweight loss scales the
the
proportionally with both the price elasticities
9 e.g the
of supply and demand. That is, the more price 1
elastic either the supply and demand of a good is, then
larger
1 the
the larger the deadweight loss. (What is the fax 00
intuition?) c fo longer
¡ The deadweight loss also scales proportionally ft is
with the size of the tax. However, the deadweight I
loss, in general, increases in a more-than-linear fashion
(e.g. doubling the tax leads to a greater than double
the deadweight loss).
DWL Yat Oa
on
D
dependent
oQ is a function of t
8

tox size COQ fats Q

DWL fee
EXAMPLE
the supply curve shifted by 4 to the left
for every quantitysupplied priceincreasedby 4
Suppose the government decides to impose a $4-
tax on the market as shown on the table to the 2C
right. IQs

_08
¡ What is the quantity bought before and after
the imposition of the tax?
before 3I after 1
¡ What is the price paid for by the buyers after
the tax?
Pbuyer 9
¡ What is the price received by the seller after
r
new Cs
the tax? 55 OLD
Pseicer
¡ By how much will CS be reduced?
12 3 Cio 7 I 1 Co9
gpo
4 tax
¡ By how much will PS be reduced? g
If
¡ What is the deadweight loss of the tax?
I t
z i 9

Ocs 5
y
l Q
 I 7,2 3

EXAMPLE (CONT)

12715 4 z 7 4
ops
1g 2

opg

Tax Revenue
AWL u OCS tops
e
f4 I 4T 4
to
490
bwc 42
7 Deadweight hose

3 9 5 54
10
 q

EXAMPLE

Suppose that a market is described by the a Q ZP

following supply and demand equations:
Q 300 P
supply
300 P
Qs = 2P
Qd = 300 – P demand
ZP
¡ Solve for the equilibrium price and quantity.
¡ Suppose that a tax T is placed on buyers.
3p Boo
I'z
Solve for the new equilibrium quantity, the b Q 300 P
demand rue
price paid by buyers, and the quantity sold. Corig
sellers
¡ Find an equation for the tax revenue as a
p zoo Q
function of T.
T shifted demal
p 300 Q
a
¡ Find an equation for the deadweight loss as a awe
function of T. Q 2P supply 11

300 Q T demand
p
EXAMPLE

Suppose that a market is described by the P 300 Z P y

following supply and demand equations: 3Pa 300 T
Qs = 2P
w p 3oo
IT ioo

In
Qd = 300 – P
¡ Solve for the equilibrium price and quantity.
¡ Suppose that a tax T is placed on buyers.
Buyer Psener tT wo
I
Solve for the new equilibrium quantity, theP Buyer 100 t
price paid by buyers, and the quantity sold.
¡ Find an equation for the tax revenue as a uemn
function of T.
Q new 2C i
2
¡ Find an equation for the deadweight loss as a
function of T. IQw 2oo
12

d pure ICT OT Quero 200 Tax T 200 T

EXAMPLE

Suppose that a market is described by the

following supply and demand equations:
Qs = 2P
Qd = 300 – P
¡ Solve for the equilibrium price and quantity.
¡ Suppose that a tax of P50 is placed on
buyers. Solve for the new equilibrium
quantity, the price paid by buyers, and the
quantity sold.
¡ Calculate the change in consumer surplus,
and the change producer surplus,
¡ Calculate the government’s tax revenue.
13
¡ Calculate the deadweight loss.
EXAMPLE
Suppose that a market is described by the
following supply and demand equations:
Qs = 2P
Qd = 300 – P
¡ Solve for the equilibrium price and quantity,
and the total surplus.
¡ Suppose that a tax of P50 is placed on buyers.
Solve for the new equilibrium quantity, the
price paid by buyers, and the quantity sold.
¡ Calculate the change in consumer surplus, and
the change producer surplus,
¡ Based on the changes in surplus, what can we
conclude about the elasticities of the parties in
this market?
¡ Calculate the government’s tax revenue.
14

¡ Calculate the deadweight loss.