Reading notes--Principles of Economics (chapter8)

Summary

Chapter 8 is Application: The Cost of Taxation. This chapter introduces the deadweight loss(welfare loss) and the relationship between tax/tax revenue and welfare loss.

Deadweight loss

• Without tax, the consumer surplus is A+B+C, the producer surplus is D+E+F.
• With tax, the tax revenue is B+D, the consumer surplus is A, the producer surplus is F.
• C+E is deadweight loss(welfare loss).
• Deadweight loss occurs when the total surplus of the consumption is smaller than the tax required. At that time, people will not consume goods, that means consumers and producers will not get surplus they should get if the tax is not imposed. Besides, tax is not levied on this consumption because this consumption does not exist.

The Determinants of the Deadweight Loss

• Each diagram has a same size of tax.
• The greater the elasticities of supply and demand, the larger the deadweight loss of a tax.

Deadweight Loss and Tax Revenue as Taxes Vary

• As the tax rate increases, the tax revenue increases first. Then it decreases.
• The deadweight loss surges as the tax rate increases(because the area of triangle is the deadweight loss).
• The curve shows that the tax revenue first increases then decreases is called Laffer curve.

Definitions

1. Deadweight loss– the fall in total surplus that results from a market distortion, such as a tax

Review

There are some exercises in this book. I recorded questions I didn’t answer correctly here.

1.A tax on a good has deadweight loss if_____(Correct answer: A)

a. the reduction in consumer and producer surplus is greater than the tax revenue

b. the tax revenue is greater than the reduction in consumer and producer surplus

c. the reduction in consumer surplus is greater than the reduction in producer surplus

d. the reduction in producer surplus is greater than the reduction in consumer surplus

My wrong answer: B

2. Eggs have a supply curve that is linear and upward-sloping and a demand curve that is linear and downward-sloping. If a 2 cent per egg tax is increased to 3 cents, the deadweight loss of the tax_____(Correct answer: C)

a. increases by less than 50 percent and may even decline

b. increases by exactly 50 percent

c. increases by more than 50 percent

d. The answer depends on whether supply or demand is more elastic

3.Peanut butter has an upward-sloping supply curve and a downward-sloping demand curve. If a 10 cent per pound tax is increased to 15 cents, the government’s tax revenue_____ (Correct answer: A)

a. increases by less than 50 percent and may even decline

b. increases by exactly 50 percent

c. increases by more than 50 percent

d. The answer depends on whether supply or demand is more elastic

Tips: As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. Because a tax reduces the size of the market, however, tax revenue does not continually increase. It first rises with the size of a tax, but if the tax gets large enough, tax revenue starts to fall.