1. Copyright © 2004 South-Western/Thomson Learning Happy Tuesday Take out your homework and please write the number of any question(s) that you would to go over in class. Then, put your homework in the bin.

2. Copyright©2004 South-Western 8 Application: The Costs of Taxation

3. Copyright © 2004 South-Western/Thomson Learning By the end of this chapter you should understand… How taxes reduce consumer and producer surplus The meaning and causes of the deadweight loss from a tax Why some taxes have larger deadweight losses than others How tax revenue and deadweight loss vary with the size of a tax

4. Copyright © 2004 South-Western/Thomson Learning Today’s LEQ How do taxes affect the economic well-being of market participants?

5. Copyright © 2004 South-Western/Thomson Learning Impact of Taxes Taxes reduce welfare of buyers & sellers Doesn’t matter who’s taxed – buyers pay more and sellers receive less.

6. Figure 1 The Effects of a Tax Copyright © 2004 South-Western Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax

7. Copyright © 2004 South-Western/Thomson Learning Impact of Taxes Now we have three participants in the market: buyers, sellers, and the government T = the size of the tax Q = the quantity of the good sold T  Q = the government’s tax revenue

8. Figure 2 Tax Revenue Copyright © 2004 South-Western Tax revenue (T × Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive

9. Figure 3 How a Tax Effects Welfare Copyright © 2004 South-Western A F B D C E Quantity 0 Price Demand Supply = PBPB Q2Q2 = PSPS Price buyers pay Price sellers receive = P1P1 Q1Q1 Price without tax

10. Copyright © 2004 South-Western/Thomson Learning Impact of Taxes With a tax, total surplus now = CS + PS + Tax Revenue Market shrinks (buyers consume less, sellers produce less) and total surplus declines This is called a deadweight loss: the fall in total surplus that results from a market distortion, such as a tax.

11. Copyright © 2004 South-Western/Thomson Learning How a Tax Affects Welfare

12. Copyright © 2004 South-Western/Thomson Learning Why Does This Happen? Tax causes some buyers and sellers to drop out of the market Tax increases price buyers have to pay (some previous buyers no longer willing to pay) Tax decreases price sellers receive (no longer covers some sellers’ opportunity costs; no point in selling)

13. Figure 4 The Deadweight Loss Copyright © 2004 South-Western Cost to sellers Value to buyers Size of tax Quantity 0 Price Demand Supply Lost gains from trade Reduction in quantity due to the tax Price without tax Q1Q1 PBPB Q2Q2 PSPS

14. Copyright © 2004 South-Western/Thomson Learning “DVD Scene Selection” Summary Congratulations! You have been hired by the Wynn Production Company to create the DVD scene selection index for the production company’s latest masterpiece, “Deadweight Loss .” The plot of the movie can be found in the subsection, “Deadweight Losses & the Gains from Trade” After reading, sketch four panels depicting key scenes in the sequence of events. Be sure to include a caption for each panel that captures key ideas and vocabulary.

15. Copyright © 2004 South-Western/Thomson Learning QUICK QUIZ #1 Draw the supply and demand curves for cookies. If the government imposes a tax on cookies, show what happens to price paid by buyers, the price received by sellers, and the quantity sold. In your diagram, show the deadweight loss from the tax. Explain the meaning of deadweight loss.

16. Copyright © 2004 South-Western/Thomson Learning DETERMINANTS OF DEADWEIGHT LOSS What determines whether the deadweight loss from a tax is large or small? ELASTICITY! The greater the elasticities of demand and supply: the larger will be the decline in equilibrium quantity and, the greater the deadweight loss of a tax.

17. Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (a) Inelastic Supply Price 0Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small.

18. Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large.

19. Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western Demand Supply (c) Inelastic Demand Price 0 Quantity Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.

20. Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (d) Elastic Demand Price 0 Quantity Size of tax Demand Supply When demand is relatively elastic, the deadweight loss of a tax is large.

21. Copyright © 2004 South-Western/Thomson Learning QUICK QUIZ #2 The demand for beer is more elastic than the demand for milk. Would a tax on beer or at ax on milk have a larger deadweight loss?

22. Copyright © 2004 South-Western/Thomson Learning QUICK QUIZ #3 Suppose both supply and demand in a market are relatively inelastic. Will a tax placed on the product in this market generate a relatively large or small deadweight loss? Why? Provide a graph to support your explanation.

23. Copyright © 2004 South-Western/Thomson Learning DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY The Deadweight Loss Debate Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic. Some examples of workers who may respond more to incentives: Workers who can adjust the number of hours they work Families with second earners Elderly who can choose when to retire Workers in the underground economy (i.e., those engaging in illegal activity)

24. Copyright © 2004 South-Western/Thomson Learning DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.

25. Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (a) Small Tax Deadweight loss PBPB Q2Q2 PSPS

26. Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Tax revenue Quantity 0 Price (b) Medium Tax PBPB Q2Q2 PSPS Supply Demand Q1Q1 Deadweight loss

27. Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (c) Large Tax PBPB Q2Q2 PSPS Deadweight loss

28. Copyright © 2004 South-Western/Thomson Learning DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY For the small tax, tax revenue is small. As the size of the tax rises, tax revenue grows. But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market.

29. Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax Copyright © 2004 South-Western (a) Deadweight Loss Deadweight Loss 0 Tax Size

30. Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax Copyright © 2004 South-Western (b) Revenue (the Laffer curve) Tax Revenue 0 Tax Size

31. Copyright © 2004 South-Western/Thomson Learning DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY As the size of a tax increases, its deadweight loss quickly gets larger. By contrast, tax revenue first rises with the size of a tax, but then, as the tax gets larger, the market shrinks so much that tax revenue starts to fall.

32. Copyright © 2004 South-Western/Thomson Learning CASE STUDY: The Laffer Curve and Supply- side Economics The Laffer curve depicts the relationship between tax rates and tax revenue. Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues.

33. Copyright © 2004 South-Western/Thomson Learning Summary A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in consumer and producer surplus usually exceeds the revenues raised by the government. The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue — is called the deadweight loss of the tax.

34. Copyright © 2004 South-Western/Thomson Learning Summary Taxes have a deadweight loss because they cause buyers to consume less and sellers to produce less. This change in behavior shrinks the size of the market below the level that maximizes total surplus.

35. Copyright © 2004 South-Western/Thomson Learning Summary As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. Tax revenue first rises with the size of a tax. Eventually, however, a larger tax reduces tax revenue because it reduces the size of the market.