THE DETERMINANTS OF THE DEADWEIGHT LOSS

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 held constant. In the demand curve is relatively inelastic and the deadweight loss is small. In the demand curve is more elastic and the deadweight loss from the tax is larger.

The lesson from this is easy to explain. A tax has a deadweight loss because it induces buyers and sellers to change their behavior. The tax raises the price paid by buyers so they consume less. At the same time the tax lowers the price received by sellers so they produce less. Because of these changes in behavior the size of the market shrinks below the optimum. The elasticities of supply and demand measure how much sellers and buyers respond to the changes in the price and therefore determine how much the tax distorts the market outcome. Hence the greater the elasticities of supply and demand the greater the deadweight loss of a tax.

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