Overview
This lecture explores how welfare economics explains the impact of taxation on market efficiency, different groups, and the size of the government, focusing on concepts like surplus analysis and deadweight loss.
Free Market and Surplus Analysis
- In a free market, equilibrium price is set by supply and demand.
- Consumer surplus is the area below the demand curve and above the price.
- Producer surplus is the area above the supply curve and below the price.
- Total surplus equals consumer surplus plus producer surplus, representing maximum market efficiency.
Effects of Taxation
- Introducing a tax creates a wedge between the price buyers pay and the price sellers receive.
- Government collects tax revenue equal to tax rate (T) times quantity sold (QT).
- Consumer and producer surplus both shrink after a tax is imposed.
- Total surplus becomes the sum of new consumer surplus, producer surplus, and tax revenue.
- Deadweight loss is the value of mutually beneficial trades that no longer occur due to the tax.
Numerical Example
- Example: Free market price is $200, quantity is 100—consumer and producer surpluses are each $10,000, total $20,000.
- With a $100 tax: buyers pay $250, sellers receive $150, quantity drops to 75.
- Consumer and producer surplus shrink; tax revenue is $7,500.
- Total surplus declines, and deadweight loss can be calculated as the reduction from the original surplus.
Determinants of Deadweight Loss
- Deadweight loss is smaller when supply or demand is inelastic (steep curves).
- When supply or demand is elastic (flat curves), deadweight loss is larger.
- Taxing goods with inelastic supply or demand minimizes economic distortions.
- Perfectly inelastic supply or demand means no deadweight loss from taxation.
Tax Policy and Government Size Debate
- Conservatives favor smaller government due to concerns about high deadweight loss from taxes.
- Liberals believe deadweight loss is smaller if labor supply is inelastic, supporting larger government spending.
- Most US federal tax revenue comes from taxing labor via income and payroll taxes.
- Elasticity of labor supply is central to debates on the true cost of taxation.
Growth of Deadweight Loss with Higher Taxes
- Deadweight loss increases more than proportionally as tax rates increase (grows exponentially).
- Broader, lower taxes create less deadweight loss than high taxes on a few items.
Key Terms & Definitions
- Consumer Surplus — Value buyers receive above the market price.
- Producer Surplus — Value sellers receive above their cost.
- Total Surplus — Combined benefit to buyers and sellers in a market.
- Deadweight Loss — Lost economic value from mutually beneficial trades that do not occur due to taxes.
- Elasticity — Measure of how much buyers/sellers respond to price changes.
Action Items / Next Steps
- Review surplus and deadweight loss calculations using triangle area formulas.
- Consider how elasticity affects tax policy in practice.