How a Tax Affects Market Participants

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 that this benefit actually accrues not to government but to those on whom the revenue is spent.

That the government’s tax revenue is represented by the rectangle between the supplyn and demand curves. The height of this rectangle is the size of the tax and the width of the rectangle is the quantity of the good sold. Because a rectangle’s area is its height times its width this rectangle’s area is which equals the tax revenue.

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