Since these effects are the same whether the tax is imposed on the buyers or on the sellers, our analysis will be simplified byNot distinguishing between these two types of taxNot showing a shift of a demand curve or supply curve in our graphs.How does a sales tax affect the economic well being of market participants?Taxes and EfficiencyConsumer surplus and taxesA tax on a good tends to increase the price of the good.The loss of consumer surplus measures how harmful the tax is to consumers.Producer surplus and taxesA tax on a good tends to decrease the amount of money a producer gets from selling the goodThe loss of producer surplus measures how harmful the tax is to producersAnother effect of a taxThe government that imposed the tax gets revenueCitizens can potentially benefit from the things on which the tax revenue is spent (education, roads)Total surplus is taken to be the sum of (Meausuring gains and losses from a tax on a good)Consumer surplus – for buyersProducer surplus – for sellersTax revenue – for government.Tax RevenueT= size of the taxQ(t)= quantity of good soldT x Q(t)= Government’s tax revenueW/o a taxCS= a+b+CPS=d+e+fTax Revenue=0Total SurplusCS + PS + TR = A+B+C+D+E+FHow a tax affects welfareA change in welfare includes changes in:CS = A smaller CSPS = F smaller PSTR = B + D Positive amount of tax revenueTax Reduces Total Surplus By C + ESmaller Overall WelfareDeadweight Loss from a tax- the difference between the total surplus without the tax and the sum of consumer surplus, producer surplus, and government revenue after the tax.(C+E) is the deadweight loss of the taxBecause of the tax, units between Q(t) and Q(e) aren’t sold.The value of these units to buyers is greater than the cost of producing them.Tax prevents some mutually beneficial trades.Determinants of the size of the deadweight lossWhat determines whether the deadweight loss from a tax is large or small?The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price.That depends on the price elasticities of supply and demand.A Per- Unit tax on goods with inelastic demand produces a smaller deadweight loss than a per- unit tax on goods with elastic demand.Because distortion (change in q) is smaller with inelastic demand.Policies:Some policy debates where “deadweight loss” should be taken into account.For some government programs, a sales tax is a “dedicated revenue source”The larger the deadweight loss (DWL)The larger the cost of the government program.When a tax causes a large DWL,These losses provide a strong argument for a leaner government program.A tax on income can be thought of as a sales tax in a labor marketFor the workers in the USFICA taxes (social security tax, medicare tax, federal state and local income taxes)The “marginal tax rate” on labor income for a typical worker is currently about 40%Places a wedge between wage that firms pay and wage that workers receive.How big should the government be?If labor supply is inelastic, then this DWL is small (which provides an argument for a relatively large government).Some economists believe labor supply is inelastic, arguing that most workers work full-time regardless of the wage.Other economists believe that at least some groups of workers have elastic supply because:Many workers can adjust their hours (by working overtime)Many families have a 2nd earner with discretion over whether and how much to work.Many elderly choose when to retire based on the wage they earn.Some people work in the “underground economy” to evade high taxes.Effects from changing the Size of the TaxPolicymakers often change taxes, raising some and lowering others.What happens to DWL when taxes change?T= Tax per UnitDoubling the tax causes the DWL to more than doubleTripling the tax causes DWL to more than triple.10-25Perfectly competitive markets produce efficient outcomesGovernment intervention not required to achieve efficiency in these markets.When markets fail to produce an efficient outcome, we call the result market failure (failing to maximize total surplus)In some markets, a decision of one agent will affect the well being of another agent.A steel firm produces steel and pollution.Sometimes firms do not bear all of the consequences or reap all of the rewards of their actions.If the costs of an agent’s decision are not entirely paid by the agent (or the benefits of an agent’s decision are not entirely reaped by the agent) we say an externality exists.When does an externality occur?Whenever a person or firm engages in an activity that influences the well-being of a bystander and yet neither pays nor receives compensation for that side-effect.Negative externalities impose costs on others.Positive externalities provides benefits to othersEx: a firm that uses pollution abatement equipmentA new invention may generate positive externalities, as does an architecturally beautiful home.When there is no government intervention in a market a negative externality or positive externality can cause the market to be inefficient.The benefit from an additional unit of a good or service that the consumer of that good or service receives will be called “private value”The demand curve shoes the private value (prices buyers are willing to pay)Private value is another term for willingness to pay of a marginal buyer.The cost of producing an additional unit of a good or service borne by the producer of that good or service will be called “private cost”The supply curve shows private cost (costs directly incurred by sellers)Private Cost is another term for the cost borne by a marginal sellerThe cost to bystanders affected adversely by a negative externality will be called an external cost.External cost is the cost of the negative impact on bystanders$1 per gallon (monetary value of harm from congestion, accidents & pollution).Social cost= private + external cost.Evaluating Market EquilibriumOur measure of society’s well being will be(consumer surplus) + (producer surplus) – (total external cost)A quantity that maximizes our measure of society’s well- being will be called a “socially optimal quantity” (or social optimum)The socially optimal quantity is determined by the intersection of the demand curve and the social cost curveThe socially optimal quantity is less than the market equilibrium quantity.A good with a negative externality Is overproduced by the market.The reason
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