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Wize University Microeconomics Textbook > Efficiency

CS and PS with Taxes

Marginal Benefit and Marginal CostPrevious Section
CS and PS with Price CeilingsNext Section
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Consumer Surplus and Producer Surplus with Taxes





Before Tax After Tax Change

Consumer Surplus
A + B + C
A
- B - C

Producer Surplus
D + E + F
F
- D - E

Government Revenue
None
B + D
+ B + D

Total Surplus
A + B + C + D + E + F
A + B + D + F
- C - E


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  • Deadweight Loss (DWL) - the change in total surplus as we go from equilibrium to the new point (after tax). It is caused by the loss in consumer and producer surplus due to the lower quantity being produced. The DWL is also called change in total surplus or change in welfare
  • The consumer and producer surplus before tax just means at equilibrium.
  • Consumer surplus after tax - we only take the area above the consumer's price (which is only triangle A) because only those consumers are still willing to buy the product (at a price of $12)
  • Producer surplus after tax - we only take the area below the producer's price (which is triangle F) because only those producers are still willing to sell the product (receiving only $8).
  • Government Revenue - this is the tax multiplied by the new quantity ($4 * 15) which is the rectangle B and D.


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Example: Tax and Elasticity


Would the Deadweight Loss (DWL) be bigger or smaller in the following situations:

1. Inelastic Supply




If supply is inelastic the deadweight loss will be
small
because the equilibrium quantity will fall by only a little bit.

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2. Inelastic Demand




If the demand is inelastic the deadweight loss will be
small
because the equilibrium quantity will fall by only a little bit.


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3. Elastic Supply



If the supply is elastic the deadweight loss will be
big
because the equilibrium quantity will fall by a lot.

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4. Elastic Demand



If demand is elastic the deadweight loss will be
big
because the equilibrium quantity will fall by a lot.

Practice: CS and PS with Taxes

If the supply is relatively inelastic, which of the following is true:
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Laffer Curve

True or False? Increasing the size of the tax will always increase tax revenue -
False

  • If the size of the tax is very high, eventually consumers will not be able to afford the product and the amount sold would fall by a lot so the government would end up collecting less in tax revenue.
  • Alternatively if the size of the tax is very low, consumers will buy a lot of the product but the government will make very little in tax per unit so tax revenue will be low.
  • Therefore a medium tax will usually result in the highest tax revenue for the government.

Laffer Curve - a curve that shows how tax revenue varies with the size of the tax. In the graph below we can see when the size of the tax is in the middle (medium tax) that is the point where the government collects the maximum tax revenue (at a tax size of 20 and tax revenue of $200).








Extra Practice
Concept Clarifier: Tax
The demand and supply for an unhealthy energy drink are given in the following diagram. Prices are in dollars and quantities are in hundreds of units. The government imposes a $1 tax on the purchase of a unit of this energy drink, paid for by the consumers at the time of the transaction.
Buyers pay
$0.25
tax on each energy drink
Sellers pay
$0.75
tax on each energy drink
Cigarettes have a downward sloping demand and an upward sloping supply curve. When the tax is increased from $4 per pack to $6 per pack, what would happen to the government's tax revenue?
Practice: Deadweight Loss
Yasmine pays Larry $40 per week for housekeeping. The government levies a $5 tax on housekeeping and Larry raises his price to $45. Yasmine continues to hire him once a week at this higher price. What is the change in producer surplus, change in consumer surplus, and deadweight loss?
Suppose you are a politician that wants to tax a product. You are hoping to increase the government's tax revenue as much as possible, while minimizing the deadweight loss. You would prefer to do this on goods with __________ elasticities of demand and __________ elasticities of supply.
The deadweight loss from taxation can be determined by:
Practice: Deadweight Loss
Yasmine pays Larry $40 per week for housekeeping. The government levies a $5 tax on housekeeping and Larry raises his price to $45. Yasmine continues to hire him once a week at this higher price. What is the change in producer surplus, change in consumer surplus, and deadweight loss?
Practice: Tax Burden
The demand and supply for an unhealthy energy drink are given in the following diagram. Prices are in dollars and quantities are in hundreds of units. The government imposes a $1 tax on the purchase of a unit of this energy drink, paid for by the consumers at the time of the transaction.