Taxes and DWL2 - In this chapter, look for the answers to...

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Unformatted text preview: In this chapter, look for the answers to these questions: How does a tax affect consumer surplus, producer surplus, and total surplus? What is the deadweight loss of a tax? What factors determine the size of this deadweight loss? CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 1 Review from Chapter 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 & sold. These effects are the same whether the tax is imposed on buyers or sellers, so we do not make this distinction in this chapter. CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 2 The Effects of a Tax With no tax, eq'm price is PE and quantity is QE . Govt imposes a tax of $T per unit. The price buyers pay is PB , the price sellers receive is PS , and quantity is QT . CHAPTER 8 P Size of tax = $T PB PE PS D S QT QE Q APPLICATION: THE COSTS OF TAXATION 3 The Effects of a Tax P The tax generates revenue equal to $ T x QT . Size of tax = $T PB PE PS D S QT CHAPTER 8 APPLICATION: THE COSTS OF TAXATION QE Q 4 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, and total surplus 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. CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 5 The Effects of a Tax Without a tax, CS = A + B + C PS = D + E + F Tax revenue = 0 Total surplus = CS + PS =A+B+C +D+E+F PE F A B D C E D S P QT CHAPTER 8 APPLICATION: THE COSTS OF TAXATION QE Q 6 The Effects of a Tax With the tax, CS = A PS = F Tax revenue =B+D Total surplus =A+B +D+F The tax causes total surplus to fall by C + E CHAPTER 8 P A PB B D PS F C E S D QT QE Q APPLICATION: THE COSTS OF TAXATION 7 The Effects of a Tax P 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. A PB B D PS F C E S D QT CHAPTER 8 APPLICATION: THE COSTS OF TAXATION QE Q 8 About the Deadweight Loss 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. CHAPTER 8 P PB S PS D QT QE Q APPLICATION: THE COSTS OF TAXATION 9 A C T I V E L E A R N I N G 1: Analysis of tax A. Compute P $ 400 The market for airplane tickets CS, PS, and total surplus without a tax. B. If $100 tax 350 300 250 200 150 100 50 0 0 25 50 75 100 125 10 S per ticket, compute CS, PS, tax revenue, total surplus, and DWL. D Q A C T I V E L E A R N I N G 1: Answers to A P $ 400 The market for airplane tickets CS = x $200 x 100 = $10,000 350 300 250 PS = x $200 x 100 P = 200 = $10,000 150 100 total surplus = $10,000 + $10,000 50 = $20,000 0 0 25 50 S D Q 75 100 125 11 A C T I V E L E A R N I N G 1: Answers to B CS = x $150 x 75 = $5,625 PS = $5,625 tax revenue = $100 x 75 = $7,500 total surplus = $18,750 DWL = $1,250 P $ 400 A $100 tax on airplane tickets 350 300 PB = 250 S 200 PS = 150 100 50 0 0 25 50 D Q 75 100 125 12 What Determines the Size of the DWL? The govt 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? Turns out it depends on the elasticities of supply and demand. Recall: The price elasticity of demand (or supply) measures how much quantity demanded (or supplied) changes when the price changes. CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 13 DWL and the Elasticity of Supply When supply is inelastic, the DWL of a tax is small. P S Size of tax D Q CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 14 DWL and the Elasticity of Supply P The more elastic is supply, the larger is the DWL. S Size of tax D Q CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 15 DWL and the Elasticity of Supply When demand is inelastic, the DWL of a tax is small. P S Size of tax D Q CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 16 DWL and the Elasticity of Supply P S The more elastic is demand, the larger is the DWL. Size of tax D Q CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 17 Why Elasticity Affects the Size of DWL A tax distorts the market outcome: consumers buy less and producers sell less, so eq'm 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. CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 18 A C T I V E L E A R N I N G 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? 19 A C T I V E L E A R N I N G 2: Answers A. Rice Krispies or sunscreen From Chapter 5: 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. 20 A C T I V E L E A R N I N G 2: Answers B. Hotel rooms in the short run or long run From Chapter 5: 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. 21 A C T I V E L E A R N I N G 2: Answers C. Groceries or meals at fancy restaurants From Chapter 5: 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. 22 ...
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