1. Taxes & Deadweight Loss
How Taxes, Subsidies and Externalities reduce efficiency
Chapter 8

2. TAXATION It does not matter if a tax is levied on buyers or sellers
The end result of a new tax is the same:
Price paid by buyers ↑
Price received by sellers ↓
Quantity sold falls (the market shrinks!)
Total Welfare falls

3. Tax Wedge
A tax places a wedge between the price buyers pay & the price sellers receive
Because of this tax wedge, quantity sold falls below the natural market equilibrium (invisible hand)
Overall, Total Welfare declines as the market shrinks

4. The Effects of a Tax E1 price paid by consumers is higher
D = MB
price received by firms is lower.
S = MC
Price buyers
pay
Price sellers
receive
Quantity
with tax
Size of tax (wedge)
Who benefits? E1
Price
without tax
Quantity
And the quantity declines.
Quantity

5. Gov’t Tax Revenue Gov’t tax revenue = Size of tax * quantity sold Tax
Price
D = MB
Gov’t tax revenue = Size of tax * quantity sold
S = MC
Quantity
with tax
Price buyers
pay
Price sellers
receive
Tax
revenue
(T × Q)
Size of tax (T)
Quantity
without tax
Quantity
sold (Q)
Quantity

6. Total Welfare Analysis After Tax
Price
A = New Consumer Surplus
(before tax = A + B + C)
D = MB
S = MC = PB Q2 PS
Price
buyers
pay
sellers
receive A F B D C E
Tax Revenue =
B + D
Area C + E is a loss to Society:
DEADWEIGHT LOSS (DWL) = P1 Q1
Price
before tax E1
F = NewProducer Surplus
(before tax = D + E + F)
QTY

7. Deadweight Loss
Deadweight loss- the fall in total surplus that results from a tax or subsidy
underproduction and overproduction both lead to deadweight loss
Effective price ceilings & price floors also produce DWL
TAX: DWL Example

8. Total Welfare after Tax
New Total Welfare = New consumer surplus + New producer surplus + tax revenue
Since the loss to buyers & sellers exceeds the tax revenue raised by the government, total welfare falls
New Total Welfare=
A + B + D + F

9. Handout: Taxes & Deadweight Loss
Price
$50
D = MB
S = MC P2 50 P3 A F B D C E
$40, P1
100
$30,
$22,
$14
Quantity