Deadweight Losses and the from Trade

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 because they have each lost of surplus. But note that the government collects no revenue from Joe and Jane because they decide to cancel their arrangement. The is pure deadweight loss. It is a loss to buyers and sellers in a market that is not offset by and increase in government revenue. From this example we can see the ultimate source of deadweight losses: taxes cause deadweight losses because they percent buyers and sellers from realizing some of the gains from trade.

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