Tax Review (from Ch 6): A tax is a wedge between the price buyers pay and the price sellers receive A tax raises the price buyers pay and lowers the price sellers receive A tax reduces the quantity bought and sold These effects are the same whether the tax is imposed on buyers or sellers

The Effects of a Tax With no tax, eq price is PE and quantity is QE . Size of tax = $T Govt imposes a tax of $T per unit. PB QT PE QE The price buyers pay is PB , PS the price sellers receive is PS , and quantity is QT .

The Effects of a Tax The tax generates revenue equal to $T x QT . P Q Size of tax = $T S PB The tax generates revenue equal to $T x QT . PE PS D QT QE

The Effects of a Tax Next, we use the tools of welfare economics to measure the gains and losses from a tax. We will determine consumer surplus (CS), producer surplus (PS), tax revenue (TR), and total surplus (TS) with and without the tax. Tax revenue is included in total surplus, because tax revenue can be used to provide services such as roads, police, public education, etc.

The Effects of a Tax Without a tax… CS = A + B + C PS = D + E + F Q D S Without a tax… A CS = A + B + C B C PS = D + E + F PE QE E D Tax revenue = 0 Total surplus = CS + PS = A + B + C + D + E + F (all) F QT

The Effects of a Tax With the tax… CS = A PS = F Tax revenue = B + D Q With the tax… A S CS = A PB B C PS = F E D Tax revenue = B + D PS D Total surplus = A + B + D + F F The tax causes total surplus to fall by C + E QT QE

The Effects of a Tax P Q A C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax. S PB B C E D PS D F QT QE

About the Deadweight Loss P Q Because of the tax, the units between QT and QE are not sold. The value of these units to buyers is greater than the cost of producing them, so the tax has prevented some mutually beneficial trades. S PB PS D QT QE

Practice Problem #1: Analysis of tax The market for airplane tickets P Q $ A. Compute CS, PS, and total surplus without a tax. B. If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL. D S In chapter 7, students learned how to compute the area of triangles representing CS, PS, and total surplus. This skill is required to do this exercise. Most students will need a calculator to do part B. Your students need not draw the graph in order to do these calculations. However, if your students have handouts of these PowerPoint slides with the graphs already on them, ask your students to shade the areas corresponding to CS, PS, and so forth directly on the printed graphs. 8

Practice problem #1: Answers to A The market for airplane tickets P Q $ CS = ½ x $200 x 100 = $10,000 D S PS = ½ x $200 x 100 = $10,000 P = total surplus = $10,000 + $10,000 = $20,000 9

Practice Problem #1: Answers to B A $100 tax on airplane tickets P Q $ CS = ½ x $150 x 75 = $5,625 D S PS = $5,625 PB = tax revenue = $100 x 75 = $7,500 PS = To compute DWL, simply subtract total surplus with the tax ($18750) from total surplus without the tax ($20,000, which was computed on the preceding slide). total surplus = $18,750 DWL = $1,250 10

What Determines the Size of the DWL? The government needs tax revenue to finance roads, schools, police, etc., so it must tax some goods and services. Which ones? One answer is that govt should tax the goods or services with the smallest DWL. So when is the DWL small vs. large? It depends on the elasticities of supply and demand.

DWL and the Elasticity of Supply Q S D When supply is inelastic, the DWL of a tax is small. Size of tax

DWL and the Elasticity of Supply Q D The more elastic is supply, the larger the DWL S Size of tax In this graph, the demand curve, equilibrium price, and size of the tax are identical to those in the graph on the preceding slide. The only thing that’s different is the supply curve here is flatter; as a result, the same size tax as before causes a larger DWL.

DWL and the Elasticity of Supply Q D S When demand is inelastic, the DWL is small Size of tax

DWL and the Elasticity of Supply Q S D The more elastic is demand, the larger the DWL Size of tax In this graph, the supply curve, equilibrium price, and size of the tax are identical to those in the graph on the preceding slide. The only thing that’s different is the demand curve here is flatter; as a result, the same size tax as before causes a larger DWL.

Why Elasticity Affects the Size of DWL A tax distorts the market outcome: consumers buy less and producers sell less, so eq Q is below the surplus-maximizing quantity. Elasticity measures how much buyers and sellers respond to changes in price, and therefore determines how much the tax distorts the market outcome.

Practice problem #2: Elasticity and DWL of a tax Would the DWL of a tax be larger if the tax were on A. Rice Krispies or sunscreen? B. Hotel rooms in the short run or hotel rooms in the long run? C. Groceries or meals at fancy restaurants? These examples (rice krispies vs. sunscreen) were chosen not because they are exciting real-world policy debates, but because they link back to the examples used in Chapter 5 to help students deduce the factors that determine elasticity. Suggestion: Display all three questions and give students a few moments to think about it. Then, proceed to the following slides… It might be worth mentioning to students: For each pair of goods, we are considering taxes of similar relative magnitude. (E.g., it wouldn’t be fair to ask whether a $10 per bottle tax on sunscreen has a bigger DWL than a $0.01 tax on boxes of Rice Krispies.) 17

Practice Problem #2: Answers A. Rice Krispies has many more close substitutes than sunscreen, so demand for Rice Krispies is more price- elastic than demand for sunscreen. So, a tax on Rice Krispies would cause a larger DWL than a tax on sunscreen. Suggestion: Display the first line, then invite students to volunteer their answers before displaying the explanation. 18

A C T I V E L E A R N I N G 2: Answers B.The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run. So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run. 19

A C T I V E L E A R N I N G 2: Answers C. Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger DWL than a tax on groceries. 20