CHAPTER+8+sl

Application: The Cost of Taxation

 * Welfare economics** is the study of how well the resources distributed affects the economic well being.



Price buyers pay: P3 Price sellers receive: P2 Price without tax: P1

A- Tax revenue (Q x P) B- deadweight los

size of the tax: Tax wedge : (P3 - P2) x Q2 Tax revenue

It does not matter whether the tax on a good is levied on buyers or sellers since tax, no matter who it was levied on, will be distributed to both buyers and sellers. Because of the tax wedge, the quantity sold falls below the level that would be sold without tax. The size of he market for this good shrinks as well.

media type="youtube" key="tUSlrQ_4Gw4" height="344" width="425" - a video illustrating how tax affects welfare and create deadweight loss due to market distortion

Deadweight loss - the fall in total surplus that reults from a market distortion, such as tax, subsidy, etc.

Tax causes deadweight loss because they prevent buyers and sllers from realizing some of the gains from trade

With each increase in the tax rate, the deaghweight loss of the tax rises even more rapidly than the size of the tax

media type="youtube" key="q01-sxyNQyg" height="344" width="425" - a video showing how tax affects welfare

The change in total welfare includes: - change in consumer surplus - change in producer surplus - change in tax revenue - losses to buyers and sellers exceeding the revenue raised by the government - change in total surplus (decrease)

What determines whether the deadweight loss from a tax is large or smalll? ELASTICITY



(a) When supply is relatively elastic, the deadweight loss of a tax is large. (b) When supply is relatively inelastic, the deadweight loss of a tax is small.

Also, the relatively elastic side pays less amount of tax. Therefore, in the market, those who have an relatively inelastic curve, that market participant pays more tax than the other.



Laffter curve- shows the relationship between tax raes and tax revenue Supply-side economics- the views of Reagan and Laffer who proposed that a tax cut would persuade people to work and thereby hae the potential to increase tax revenues.

Questions for Review 1) Assuming that this market has a fixed supply curve, which one would have a larger deadweight loss? a. An inelastic demand curve b. A elastic demand curve

2) As illustrated in the Laffer Curve, why does tax revenue shrink back as more amount of tax is levied upon the market?

3) Who would pay less amount of tax in this market?



1) A elastic demand curve would create a larger deadweight loss. 2) As the size of the tax contincues to rise, tax revenue falls becuase the hiher tax reduces the size of the market. 3) Since the supply curve is relatively inelastice, the tax is levied more on the sellers.