What did you study last time?

1. CRC Economics

2. What did you study last time? • Consumer surplus, producer surplus, and total surplus • Market efficiency • Market failures CRC Economics

3. Do you know … • how unit-tax taxes affect markets? • what a deadweight loss (DWL) is and what determines it? • how a deadweight loss and tax revenue (GTR) are related? CRC Economics

4. 1. Effects of a unit tax on a market The diagram below shows a market. P The market equilibrium price is Pe, and the equilibrium quantity Qe. Now the government imposes per-unit tax, T, on the market. T S E Pe D CRC Economics Q Qe

5. 1. Effects of a unit tax on a market Market output falls to Qt. (Qt < Qe) P Buyers pay more at Pdt. (Pdt > Pe) Sellers receive less at Pst. (Pst < Pe) T S Pdt E Pe Pst D CRC Economics Q Qt Qe

6. 1. Effects of a unit tax on a market Buyers’ tax share is Td = Td/unit * Qt = (Pdt – Pe) * Qt P Sellers’ tax share is Ts = Ts/unit * Qt = (Pe – Pst) * Qt The government collects tax revenue, GTR = Td + Ts T S Pdt Td GTR E Pe Ts Pst D CRC Economics Q Qt Qe

7. 1. Effects of a unit tax on a market P There exists a deadweight loss (DWL). T S Pdt GTR Td DWL E Pe Ts DWL Pst D CRC Economics Q Qt Qe

8. 1. Effects of a unit tax on a market The diagram below shows a market. The market equilibrium price is Pe, and the equilibrium quantity Qe. P TS = CS + PS = maximum A free market is efficient. CS S E Pe PS D CRC Economics Q Qe

9. 1. Effects of a unit tax on a market Now the government imposes a per-unit tax, T, on the market. Market output falls to Qt. P CS falls to CSt and PS falls to PSt. Governments collect tax revenue, GTR. CSt CS T S GTR E Pe PS D PSt CRC Economics Q Qt Qe

10. 1. Effects of a unit tax on a market There exists a DWL, equal to the reduction in TS.DWL = ½ * T * (Qe – Qt) P The market becomes inefficient. CS CSt T S GTR DWL E Pe PS DWL D PSt CRC Economics Q Qt Qe

11. 1. Effects of a unit tax on a market • Buyers pay more. Their welfare (CS) falls. • Sellers receive less. Their welfare (PS) falls. • Quantity sold falls, i.e. Qt < Qe. • Government gains revenue, GTR. • Total surplus (TS) falls, i.e. there exists a deadweight loss (DWL). CRC Economics

12. 1. Effects of a unit tax on a market • The losses to buyers and sellers due to a tax exceed the revenue raised by the government. • The difference, equal to the reduction in TS, is called the deadweight loss. • Taxes distort incentives, they cause markets to allocate resources inefficiently. CRC Economics

13. 2. The lost gains from trade = DWL The diagram below shows a market. The market equilibrium price is Pe, and the equilibrium quantity Qe. P The government imposes a per-unit tax, T, on the market. T S E Pe D CRC Economics Q Qe

14. 2. The lost gains from trade = DWL Market production falls to Qt. At Qt, WTP = MB > WTR = MC, i.e.the value to buyers > the cost to sellers. P The lost gains from trade, due to production loss Qe-Qt, is called the DWL. WTP = MB T S DWL E Pe DWL WTR = MC D CRC Economics Q Qt Qe

15. 2. The lost gains from trade = DWL • DWL is the reduction in total surplus due to a tax. • DWL is also the lost gains from trade. Taxes cause DWL because they prevent buyers and sellers from realizing some of the gains from trade. • Lost production causes the value to buyers to exceed the cost to sellers; the difference is the DWL. CRC Economics

16. 2. The lost gains from trade = DWL • The case of a labor tax: A labor tax places a wedge between the wage that firms pay and the wage that workers receive. • Does a labor tax cause a large or a small DWL in the labor market? • It all depends on the elasticity of labor supply. CRC Economics

17. 3a. DWL & supply elasticity Es The diagram shows a market with an inelastic supply. At E, Ed = 1 > Es. P Now the government imposes a tax T on the market. Production falls a little and a small DWL exists. T Si E DWL Pe DWL D CRC Economics Q Qt,i Qe

18. 3a. DWL & supply elasticity Es If the supply curve is elastic instead, i.e. at E, Ed = 1 < Es. P The same tax size will result in a larger production loss and a larger DWL. Si T Se DWL E DWL Pe DWL DWL D CRC Economics Q Qt,e Qt,i Qe

19. 3a. DWL & supply elasticity Es Conclusion: The more elastic is the supply, the larger the production loss, and the larger the DWL. P Si T Se DWL E DWL Pe DWL DWL D CRC Economics Q Qt,e Qt,i Qe

20. 3b. DWL & demand elasticity Ed The diagram shows a market with an inelastic demand. At E, Ed < 1 = Es. P Now the government imposes a tax T on the market. Production falls a little and a small DWL exists. Sue T DWL Pe E DWL Di CRC Economics Q Qt,i Qe

21. 3b. DWL & demand elasticity Ed If the demand curve is elastic instead, i.e. at E, Ed > 1 = Es. P The same tax size will result in a larger production loss and a larger DWL. Sue T DWL DWL Pe E DWL DWL De Di CRC Economics Q Qt,e Qt,i Qe

22. 3b. DWL & demand elasticity Ed Conclusion: The more elastic is the demand, the larger the production loss, and the larger the DWL. P Sue T DWL DWL Pe E DWL DWL De Di CRC Economics Q Qt,e Qt,i Qe

23. 3c. The lost gains from trade = DWL • The size of DWL is determined by the relative elasticity of supply and demand. • Greater D/S elasticities lead to greater production loss and thus greater DWL. • Example: labor tax, such as Social Security tax, Medicare tax, income tax. CRC Economics

24. 3c. The lost gains from trade = DWL • If labor supply is inelastic, labor tax is not distorting because the DWL is small. • If labor supply is elastic, labor tax is highly distorting, because the DWL is large. CRC Economics

25. 3c. The lost gains from trade = DWL • Labor taxes encourage: • workers to work fewer hours; • second earners to stay home; • the elderly to retire early; and • the unscrupulous to enter the underground economy. CRC Economics

26. 4. Tax size (T), DWL, and tax revenue (GTR) The diagram below shows a market. P The tax size T1 results in DWL1 and GTR1. The larger tax size T2 results in a larger DWL2 and a smaller GTR2. T2 GTR2 DWL2 T1 S GTR1 DWL1 E Pe D CRC Economics Q Qt2 Qe

27. 4. Tax size (T), DWL, and tax revenue (GTR) Conclusion: As T rises, DWL becomes larger, and GTR first increases but eventually decreases. P T2 GTR2 DWL2 T1 S GTR1 DWL1 E Pe D CRC Economics Q Qt2 Qe

28. 4. Tax size (T), DWL, and tax revenue (GTR) As T rises, DWL rises. DWL DWL DWL3 DWL2 DWL1 CRC Economics T1 T2 T3 T

29. 4. Tax size (T), DWL, and tax revenue (GTR) As T rises, GTR first rises and then falls. GTR GTR2 GTR1 GTR4 Laffer curve CRC Economics T1 T2 T3 T4 T

30. 4. Tax size (T), DWL, and tax revenue (GTR) • Higher tax sizes lead to higher DWL and eventually lower tax revenue. • The Laffer curve shows the relationship between tax size and tax revenue. CRC Economics

31. 4. Tax size (T), DWL, and tax revenue (GTR) • Supply-side economics advocates that lower taxes would give people the incentive to work more, which would raise economic well-being, and perhaps even tax revenue. CRC Economics

32. Now you know … • how unit-taxes affect markets. • what a deadweight loss, DWL, is and what determines it. • how a deadweight loss and tax revenue, GTR, are related. CRC Economics

33. What did you study this time? Chapter 8Application: The Costs of Taxation • The deadweight loss of taxation • The determinants of the deadweight loss • Deadweight loss and tax revenue as taxes vary CRC Economics

34. What will you study next time? Chapter 9Application: International Trade • What are the determinants of trade? • The winners and losers from trade • The arguments for restricting trade CRC Economics

35. See You! Take Care! CRC Economics