Understanding Taxes and Deadweight Loss

Sep 16, 2024

Lecture on Taxes and Deadweight Loss

Introduction

  • Examined the effect of taxes on market prices.
  • Focus on why taxes are levied: to generate revenue.
  • Discussion on the cost of raising revenue, known as deadweight loss.

Market Equilibrium

  • Initial equilibrium without tax:
    • Price = $2
    • Quantity exchanged = 700 units
  • Consumer Surplus: Area under the demand curve and above price up to quantity exchanged (green area).
  • Producer Surplus: Area above the supply curve up to quantity exchanged and below price (blue area).
  • Free markets maximize consumer and producer surplus.

Effect of Taxes

  • Introduction of a $1 tax:
    • New buyer’s price = $2.50
    • Quantity exchanged drops to 500 units.
  • Consumer Surplus:
    • Decreases as price increases and quantity exchanged decreases.
  • Producer Surplus:
    • Decreases as the seller's price decreases.
  • Tax Revenue:
    • $1 tax times 500 exchanged units = Tax revenue area.
  • Deadweight Loss:
    • Represents lost gains from trade due to reduced quantity exchanged (200 units not traded).

Understanding Deadweight Loss

  • Illustrated with example of a bus trip:
    • Without tax: trip yields a net benefit of $10.
    • With tax: cost exceeds benefit, trip not taken, resulting in deadweight loss of $10.
  • Key Concept: Deadweight loss represents the value of trades not made due to tax.

Taxation and Elasticity

  • Deadweight loss is larger with more elastic demand curves.
  • Taxation Strategy:
    • Prefer taxing goods with inelastic demand to minimize deadweight loss.

Case Study: Luxury Yacht Tax

  • 1990 federal luxury tax on goods including yachts:
    • Expected revenue: $31 million.
    • Actual revenue: $16.6 million due to drop in yacht sales.
    • Resulted in job loss and higher unemployment payouts.
  • Lesson: Avoid taxing goods with elastic demands to prevent high deadweight loss and unintended consequences.

Conclusion

  • Deadweight loss occurs when trades are deterred by taxes, reducing potential gains from trades.
  • Next topic: subsidies as negative taxes.

Next Steps

  • Option to test understanding with practice questions.
  • Proceed to the next video for further learning.