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Supply demand elasticity deadweight loss all this economic theory is enough to make your hard spin. But believe it or not these ideas go to the heart of a profound question: How big should the government be? The debate hinges on these concepts because the larger the deadweight loss of taxation the larger the cost of any government program. If taxation entails large deadweight losses then these losses are a strong argument for a leaner government that does less and taxes less. But if taxes impose small deadweight losses then government programs are less costly than otherwise might be.  So how big are the the deadweight losses of taxation? This is a question about which economists disagree. To see the nature of this disagreement consider the most important tax in the U.S economy: the tax on labor. The Social Security tax the Medicare tax and to a large extent the federal income tax are labor taxes. Many state   goverments also tax labor earnings. A labor tax places a wedge

What determines whether the deadweight loss from a tax is large or small? The answer is the price elasticities of supply and demand which measure how much the quantity supplied and quantity demanded respond to changes in the price. Let’s consider first how the elasticity of supply affects the size of the deadweight loss. In the top two panels of the demand curve and the size of the tax are the same. The only difference in these figures is the elasticity of the supply curve. In the supply curve is relatively inelastic. Quantity supplied responds only slightly to changes in the price. In the supply curve is relatively is relatively elastic: Quantity supplied responds substantially to changes in the price. Notice that the deadweight loss the area of the triangle between the supply and demand curves is larger when the supply curve is more elastic. Show how the elasticity of demand affects the size of the deadweight loss. Here the supply curve and the size of the tax are h

To gain some intuition for why taxes result in deadweight losses consider an example. Imagine that joe cleans Jane’s house each week. The opportunity cost of Joe’s time is and the value of a clean house   to Jane. Thus Joe and Jane each receive a benefit from their deal. The total surplus of measures the gains from trade in this particular transaction. Now suppose that the government levies a tax on the providers of cleaning services. There is now price that Jane can pay Joe that will leave both of them better off after   paying the tax. The most Jane would be willing to pay is but then Joe would be left with only after paying the tax which is less than his opportunity cost. Conversely hor Joe to receive his opportunity cost of Jane would need to which is above the value she places on a clean house. As a result Jane and Joe cancel their arrangement. Joe goes without the income and Jane lives in a dirtier house.  The tax has made Joe and Jane worse off by a total of be

Now let’s use the tools of welfare economics to measure the gains and losses from a tax on a good. To do this we must take into account how the tax affects buyers sellers and the government. The benefit received by buyers in a market is measured b consumer surplus the amount buyers are willing to pay for the good minus the amount they actually pay for it. The benefit received by sellers in a market is measured by producer surplus the amount sellers receive for the good minus their costs. These are precisely the measures of economic welfare we used in. What about the third interested party the government? If T is the size of the tax and is the quantity of the good sold then the government gets total tax revenue. It can use this tax revenue to provide services such as roads police and public education or to help the needy. Therefore to analyze how taxes affect economic well-being we use tax revenue to measure the government’s benefit from the tax. Keep in mind however   tha

We begin by recalling one of the surprising lessons. It does not matter whether a tax on a good is levied on buyers or sellers of the good. When a tax is levied on buyers the demand curve shifts downward by the size of the tax when it is levied on sellers the supply curve shifts upward by that amount. In either case when the tax is enacted the price paid by buyers rises and the price received by sellers falls. In the end buyers and sellers share the burden of the tax regardless of how it is levied. To simplify our discussion this a shift in either the supply or demand curve although one curve must shift. Which curve shifts depends on whether the tax is levied on sellers the supply curve shifts or buyers the demand curve shifts. In this chapter we can simplify the graphs by not bothering to shows the shift. The key result for our purposes here is that tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge the quantity so