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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