Page 164 - The Principle of Economics

166 PART THREE
SUPPLY AND DEMAND II: MARKETS AND WELFARE
Figure 8-4
Size of tax
Value to buyers
Lost gains from trade
Cost to sellers
Supply
Demand
THE DEADWEIGHT LOSS. When
the government imposes a tax on
a good, the quantity sold falls
from Q1 to Q2. As a result, some
of the potential gains from trade PB among buyers and sellers do not
Price
Price without tax
PS
0 Q2 Q1
Reduction in quantity due to the tax
get realized. These lost gains from trade create the deadweight loss.
Quantity
deadweight loss: It is a loss to buyers and sellers in a market not offset by an increase in government revenue. From this example, we can see the ultimate source of deadweight losses: Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.
The area of the triangle between the supply and demand curves (area C + E in Figure 8-3) measures these losses. This loss can be seen most easily in Figure 8-4 by recalling that the demand curve reflects the value of the good to consumers and that the supply curve reflects the costs of producers. When the tax raises the price to buyers to PB and lowers the price to sellers to PS, the marginal buyers and sell- ers leave the market, so the quantity sold falls from Q1 to Q2. Yet, as the figure shows, the value of the good to these buyers still exceeds the cost to these sellers. As in our example with Joe and Jane, the gains from trade—the difference between buyers’ value and sellers’ cost—is less than the tax. Thus, these trades do not get made once the tax is imposed. The deadweight loss is the surplus lost because the tax discourages these mutually advantageous trades.
QUICK QUIZ: Draw the supply and demand curve for cookies. If the government imposes a tax on cookies, show what happens to the quantity sold, the price paid by buyers, and the price paid by sellers. In your diagram, show the deadweight loss from the tax. Explain the meaning of the deadweight loss.
THE DETERMINANTS OF THE DEADWEIGHT LOSS
What determines whether the deadweight loss from a tax is large or small? The an- swer is the price elasticities of supply and demand, which measure how much the quantity supplied and quantity demanded respond to changes in the price.