microeconomic

Consumer Surplus. Producer Surplus. Total Surplus. How are these concepts used to explain welfare economics? How are these concepts used to explain the benefits of trade? How are these concepts used to explain why restricting trade reduces societal wellbeing? 

(Should trade be restricted in some circumstances, like the sale of organs ect, or should these ideas apply to these circumstances too?) 

(Use the concepts from Chapter 7 and 8, and elaborate on some practical impact you find from the chapter. Don’t feel limited by the prompt.)

Remember to respond to two other posts.

Consumers, Producers, and the Efficiency of Markets

CHAPTER

7

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8 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

1

PowerPoint Slides prepared by:

V. Andreea CHIRITESCU

Eastern Illinois University

N. GREGORY MANKIW

PRINCIPLES OF
MICROECONOMICS
Eight Edition

1

Consumer Surplus

Welfare economics

The study of how the allocation of resources affects economic well-being

Benefits that buyers and sellers receive from engaging in market transactions

How society can make these benefits as large as possible

In any market, the equilibrium of supply and demand maximizes the total benefits received by all buyers and sellers combined

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

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Consumer Surplus
Willingness to pay
Maximum amount that a buyer will pay for a good
How much that buyer values the good
Consumer surplus
Amount a buyer is willing to pay for a good minus amount the buyer actually pays
Willingness to pay minus price paid
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Table 1 Four Possible Buyers’ Willingness to Pay
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Consumer Surplus
Consumer surplus
Measures the benefit buyers receive from participating in a market
Closely related to the demand curve
Demand schedule
Derived from the willingness to pay of the possible buyers
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Figure 1 The Demand Schedule and the Demand Curve
The table shows the demand schedule for the buyers (listed in Table 1) of the mint-condition copy of Elvis Presley’s first album. The graph shows the corresponding demand curve. Note that the height of the demand curve reflects the buyers’ willingness to pay.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
$100
80
70
50
Price of Albums
0
4
3
1
2
Quantity of Albums
Taylor’s willingness to pay
Carrie’s willingness to pay
Rihanna’s willingness to pay
Gaga’s willingness to pay
Demand

Consumer Surplus
At any quantity, the price given by the demand curve
Shows the willingness to pay of the marginal buyer
The buyer who would leave the market first if the price were any higher
Consumer surplus in a market
Area below the demand curve and above the price
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Figure 2 Measuring Consumer Surplus with the Demand Curve
In panel (a), the price of the good is $80 and the consumer surplus is $20.
In panel (b), the price of the good is $70 and the consumer surplus is $40.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
$100
80
70
50
Price of
Albums
0
4
3
1
2
Quantity of Albums
Taylor’s consumer
surplus ($20)
Demand
(a) Price = $80
$100
80
70
50
Price of
Albums
0
4
3
1
2
Quantity of Albums
Taylor’s consumer
surplus ($30)
(b) Price = $70
Carrie’s consumer
surplus ($10)
Total consumer
surplus ($40)
Demand

Consumer Surplus
A lower price raises consumer surplus
Existing buyers: increase in consumer surplus
Buyers who were already buying the good at the higher price are better off because they now pay less
New buyers enter the market: increase in consumer surplus
Willing to buy the good at the lower price
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Figure 3 How Price Affects Consumer Surplus
In panel (a), the price is P1, the quantity demanded is Q1, and consumer surplus equals the area of the triangle ABC.
When the price falls from P1 to P2, as in panel (b), the quantity demanded rises from Q1 to Q2 and the consumer surplus rises to the area of the triangle ADF. The increase in consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area BCED) and in part because new consumers enter the market at the lower price (area CEF).
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
0
Quantity
(a) Consumer Surplus at Price P1
(b) Consumer Surplus at Price P2
Demand
Q1
Consumer
surplus
B
C
A
Price
0
Quantity
Demand
Initial
consumer
surplus
A
Q2

B
D

C
E
F
Additional consumer surplus to initial consumers
Consumer surplus
to new consumers
Q1
P2
P1
P1

Consumer Surplus
Consumer surplus
Benefit that buyers receive from a good
As the buyers themselves perceive it
Good measure of economic well-being
Exception: illegal drugs
Drug addicts are willing to pay a high price for heroin
Society’s standpoint: drug addicts don’t get a large benefit from being able to buy heroin at a low price
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Producer Surplus
Cost
Value of everything a seller must give up to produce a good
Measure of willingness to sell
Producer surplus
Amount a seller is paid for a good minus the seller’s cost of providing it
Price received minus willingness to sell
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Table 2 The Costs of Four Possible Sellers
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Producer Surplus
Producer surplus
Closely related to the supply curve
Supply schedule
Derived from the costs of the suppliers
At any quantity
Price given by the supply curve shows the cost of the marginal seller
Seller who would leave the market first if the price were any lower
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Figure 4 The Supply Schedule and Supply Curve
The table shows the supply schedule for the sellers (listed in Table 2) of painting services. The graph shows the corresponding supply curve. Note that the height of the supply curve reflects the sellers’ costs.
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$900
800
600
500
Price of House Painting
0
4
3
1
2
Quantity of Houses Painted
Vincent’s cost
Claude’s cost
Pablo’s cost
Andy’s cost
Supply

Producer Surplus
Supply curve
Reflects sellers’ costs
Used to measure producer surplus
Producer surplus in a market
Area below the price and above the supply curve
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Figure 5 Measuring Producer Surplus with the Supply Curve
In panel (a), the price of the good is $600 and the producer surplus is $100.
In panel (b), the price of the good is $800 and the producer surplus is $500.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
$900
800
600
500
Price of House Painting
$900
800
600
500
Price of House Painting
0
4
3
1
2
Quantity of Houses Painted
Andy’s producer
surplus ($100)
Supply
(a) Price = $600
(b) Price = $800
Andy’s producer
surplus ($300)
Pablo’s producer
surplus ($200)
Total producer
surplus ($500)
0
4
3
1
2
Quantity of Houses Painted
Supply

Producer Surplus
A higher price raises producer surplus
Existing sellers: increase in producer surplus
Sellers who were already selling the good at the lower price are better off because they now get more for what they sell
New sellers enter the market: increase in producer surplus
Willing to produce the good at the higher price
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Figure 6 How Price Affects Producer Surplus
In panel (a), the price is P1, the quantity supplied is Q1, and producer surplus equals the area of the triangle ABC.
When the price rises from P1 to P2, as in panel (b), the quantity supplied rises from Q1 to Q2 and the producer surplus rises to the area of the triangle ADF. The increase in producer surplus (area BCFD) occurs in part because existing producers now receive more (area BCED) and in part because new producers enter the market at the higher price (area CEF).
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
0
Quantity
(a) Producer Surplus At Price P1
(b) Producer Surplus At Price P2
Supply
P1
Q1
Producer
surplus
B
C
A
Price
0
Quantity
Supply
P1
Q1
Initial
producer
surplus
A
P2
Q2

B
D

C
E
F
Additional producer surplus to initial producers
Producer surplus
to new producers

Market Efficiency
The benevolent social planner
All-knowing, all-powerful, well-intentioned dictator
Wants to maximize the economic well-being of everyone in society
Economic well-being of a society
Total surplus
Sum of consumer and producer surplus
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Market Efficiency
Total surplus = Consumer surplus + Producer surplus
Consumer surplus = Value to buyers – Amount paid by buyers
Producer surplus = Amount received by sellers – Cost to sellers
Amount paid by buyers = Amount received by sellers
Total surplus = Value to buyers – Cost to sellers
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Market Efficiency
Efficiency
Property of a resource allocation
Maximizing the total surplus received by all members of society
Equality
Property of distributing economic prosperity uniformly among the members of society
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Market Efficiency
Gains from trade in a market
Like a pie to be shared among the market participants
The question of efficiency
Whether the pie is as big as possible
The question of equality
How the pie is sliced
How the portions are distributed among members of society
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Market Efficiency
Market outcomes
Free markets allocate the supply of goods to the buyers who value them most highly
Measured by their willingness to pay
Free markets allocate the demand for goods to the sellers who can produce them at the least cost
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Figure 7 Consumer and Producer Surplus in the Market Equilibrium
Total surplus—the sum of consumer and producer surplus—is the area between the supply and demand curves up to the equilibrium quantity.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
0
Quantity
Equilibrium
quantity

Equilibrium
price
Demand
Supply
Consumer
surplus
Producer
surplus
B
C
A
D
E

Market Efficiency
At market equilibrium, social planner
Cannot increase economic well-being by
Changing the allocation of consumption among buyers
Changing the allocation of production among sellers
Cannot rise total economic well-being by
Increasing or decreasing the quantity of the good
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Market Efficiency
Market outcomes
Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus
Market equilibrium
Efficient allocation of resources
The benevolent social planner
“Laissez faire” = “let people do as they will”
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Figure 8 The Efficiency of the Equilibrium Quantity
At quantities less than the equilibrium quantity, such as Q1, the value to buyers exceeds the cost to sellers.
At quantities greater than the equilibrium quantity, such as Q2, the cost to sellers exceeds the value to buyers.
Therefore, the market equilibrium maximizes the sum of producer and consumer surplus.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
0
Quantity
Equilibrium
quantity
Demand
Supply
Q1
Q2
Value
to
buyers
Value
to buyers
Cost
to
sellers
Cost
to sellers
Value to buyers is greater than cost to sellers
Value to buyers is less than cost to sellers

Market Efficiency
Adam Smith’s invisible hand
Takes all the information about buyers and sellers into account
Guides everyone in the market to the best outcome
Economic efficiency
Free markets
Best way to organize economic activity
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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ASK THE EXPERTS
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Supplying Kidneys
“A market that allows payment for human kidneys should be established on a trial basis to help extend the lives of patients with kidney disease.”

Should there be a market for organs?
“How a mother’s love helped save two lives”
Ms. Stevens – her son needed a kidney transplant
The mother’s kidney was not compatible
Donated one of her kidneys to a stranger
Her son was moved to the top of the kidney waiting list
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Should there be a market for organs?
Questions
Trade a kidney for a kidney?
Trade a kidney for an expensive, experimental cancer treatment?
Exchange her kidney for free tuition for her son?
Sell her kidney for cash?
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Should there be a market for organs?
Current public policy
Illegal for people to sell their organs
Government has imposed a price ceiling of zero: shortage
Large benefits to allowing a free market in organs
People are born with two kidneys
Usually need only one
Few people – no working kidney
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Should there be a market for organs?
Current situation
Typical patient waits several years for a kidney transplant
Every year, thousands of people die because a kidney cannot be found
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Should there be a market for organs?
Allow for kidney market
Balance supply and demand
Sellers get extra cash in their pockets
Buyers get to live
No more shortage of kidneys
Efficient allocation of resources
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Should there be a market for organs?
Critics: worry about fairness
Benefit the rich at the expense of the poor
Current system: is it fair?
Some people have an extra kidney they don’t really need
Others are dying to get one
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Market Efficiency & Market Failure
Forces of supply and demand
Allocate resources efficiently
Several assumptions about how markets work
Markets are perfectly competitive
Outcome in a market matters only to the buyers and sellers in that market
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Market Efficiency & Market Failure
When these assumptions do not hold
“Market equilibrium is efficient” may no longer be true
In the world, competition is far from perfect
Market power
A single buyer or seller (small group)
Control market prices
Markets are inefficient
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Market Efficiency & Market Failure
In the world
Decisions of buyers and sellers
Affect people who are not participants in the market at all
Externalities – cause welfare in a market to depend on more than just the value to the buyers and the cost to the sellers
Inefficient equilibrium – from the standpoint of society as a whole
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Market Efficiency & Market Failure
Market failure
E.g.: market power and externalities
The inability of some unregulated markets to allocate resources efficiently
Public policy
Can potentially remedy the problem and increase economic efficiency
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Application:

The Costs of Taxation

CHAPTER

8

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8 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

1

PowerPoint Slides prepared by:

V. Andreea CHIRITESCU

Eastern Illinois University

N. GREGORY MANKIW

PRINCIPLES OF
MICROECONOMICS
Eight Edition

1

Deadweight Loss of Taxation

Tax on a good levied on buyers

Demand curve shifts downward

By the size of tax

Tax on a good levied on sellers

Supply curve shifts upward

By the size of tax
2

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Deadweight Loss of Taxation
Tax on a good levied on buyers or on sellers
Same outcome: a price wedge
Price paid by buyers rises
Price received by sellers falls
Lower quantity sold
3
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Deadweight Loss of Taxation
Tax burden
Distributed between producers and consumers
Determined by elasticities of supply and demand
Market for the good
Smaller
4
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Figure 1 The Effects of a Tax
A tax on a good places a wedge between the price that buyers pay and the price that sellers receive.
The quantity of the good sold falls.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
Demand
Supply
Price buyers pay
Price without tax
Price sellers receive
Size of tax

Quantity
with tax
Quantity
without tax

Deadweight Loss of Taxation
Economic welfare
Buyers: consumer surplus
Sellers: producer surplus
Government: total tax revenue
Tax times quantity sold
Public benefit from the tax
6
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
“You know, the idea of taxation with representation doesn’t appeal to me very much, either.”

Figure 2 Tax Revenue
The tax revenue that the government collects equals T × Q, the size of the tax T times the quantity sold Q. Thus, tax revenue equals the area of the rectangle between the supply and demand curves.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
Demand
Supply
Quantity
without tax
Size of tax (T)

Tax
revenue
T ˣ Q
Price buyers pay
Price sellers receive

Quantity sold (Q)
Quantity
with tax

Figure 3 How a Tax Affects Welfare
A tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E).
Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E).
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
A
B
D
F
Q1
C
E
Q2
Supply
Demand
Price
buyers
pay
=PB
Price
sellers
receive
=PS
Price
without
tax
=P1

Deadweight Loss of Taxation
Welfare without a tax
Consumer surplus, areas A, B, and C
Producer surplus, areas D, E, and F
Total tax revenue = 0
Welfare with tax
Smaller consumer surplus, area A
Smaller producer surplus, area F
Total tax revenue, areas B and D
Smaller overall welfare
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Deadweight Loss of Taxation
Losses of surplus to buyers and sellers, from a tax
Exceed the revenue raised by the government
Deadweight loss
Fall in total surplus that results from a market distortion, such as a tax
Taxes distort incentives
Markets allocate resources inefficiently
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Deadweight Loss of Taxation
Deadweight losses and gains from trade
Taxes cause deadweight losses
Prevent buyers and sellers from realizing some of the gains from trade
The gains from trade
Difference between buyers’ value and sellers’ cost are less than the tax
Once the tax is imposed some trades are not made: deadweight loss
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Figure 4 The Source of a Deadweight Loss
When the government imposes a tax on a good, the quantity sold falls from Q1 to Q2.
At every quantity between Q1 and Q2, the potential gains from trade among buyers and sellers are not realized. These lost gains from trade create the deadweight loss.
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Price
Quantity
0
Demand
Supply
Q1
PS
Price without tax
PB
Q2
Size of tax
Value to
buyers
Cost to
sellers
Lost gains
from trade
Reduction in quantity due to the tax

Determinants of Deadweight Loss
Price elasticities of supply and demand
More elastic supply curve
Larger deadweight loss
More elastic demand curve
Larger deadweight loss
The greater the elasticities of supply and demand
The greater the deadweight loss of a tax
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Figure 5 Tax Distortions and Elasticities (a, b)
In panels (a) and (b), the demand curve and the size of the tax are the same, but the price elasticity of supply is different. Notice that the more elastic the supply curve, the larger the deadweight loss of the tax.
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Price
Quantity
0
(a) Inelastic Supply
(b) Elastic Supply
When supply is relatively inelastic, the deadweight loss of a tax is small
Price
Quantity
0
When supply is relatively elastic, the deadweight loss of a tax is large
Demand
Supply
Demand
Supply
Size
of tax
Size
of tax

Figure 5 Tax Distortions and Elasticities (c, d)
In panels (c) and (d), the supply curve and the size of the tax are the same, but the price elasticity of demand is different. Notice that the more elastic the demand curve, the larger the deadweight loss of the tax.
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Price
Quantity
0
(c) Inelastic Demand
(d) Elastic Demand
Demand
Supply
When demand is relatively inelastic, the deadweight loss of a tax is small
Price
Quantity
0
Demand
Supply
When demand is relatively elastic, the deadweight loss of a tax is large
Size
of tax
Size
of tax

The deadweight loss debate
How big should the government be?
The larger the deadweight loss of taxation
The larger the cost of any government program
If taxes impose large deadweight losses
These losses are a strong argument for a leaner government that does less and taxes less
If taxes impose small deadweight losses
Government programs are less costly
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The deadweight loss debate
How big are the deadweight losses of taxation?
Economists disagree
Tax on labor (the labor tax)
Social Security tax, Medicare tax, much of federal income tax
Places a wedge between the wage that firms pay and the wage that workers receive
Marginal tax rate on labor income is 40% (tax rate on the last dollar of earnings)
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The deadweight loss debate
40% labor tax: Small or large deadweight loss?
Some believe labor supply
is fairly inelastic
Almost vertical
Most people would work full-time regardless of wage
Tax on labor: small deadweight loss
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“What’s your position on the elasticity of labor supply?”

The deadweight loss debate
Others: labor supply is more elastic
Tax on labor: greater deadweight loss
Many workers can adjust the number of hours they work (overtime)
Some families have second earners; some discretion over whether to do unpaid work at home or paid work in the marketplace
Many of the elderly can choose when to retire
Some people consider engaging in illegal economic activity (underground economy)
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Deadweight Loss & Tax Revenue
As the tax increases
Deadweight loss increases
Even more rapidly than the size of the tax
Tax revenue
Increases initially
Then decreases
The higher tax: drastically reduces the size of the market
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Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (a, b, c)
The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount of the tax multiplied by the amount of the good sold.
In panel (a), a small tax has a small deadweight loss and raises a small amount of revenue.
In panel (b), a somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue.
In panel (c), a very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue.
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Price
Quantity
0
(a) Small tax
Demand
Supply
Deadweight loss
Q1
PB
PS
Q2
Tax
revenue
Price
Quantity
0
(b) Medium tax
Demand
Supply
Deadweight loss
Q1
PB
PS
Q2
Tax
revenue
Price
Quantity
0
(c) Large tax
Demand
Supply
Deadweight loss
Q1
PB
PS
Q2
Tax revenue

Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (d, e)
Panels (d) and (e) summarize these conclusions.
Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger.
Panel (e) shows that tax revenue first rises and then falls. This relationship is called the Laffer curve.
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Deadweight loss
Tax size
0
(d) From panel (a) to panel (c),
deadweight loss continually increases
(e) From panel (a) to panel (c), tax
revenue first increases, then decreases

Tax Revenue
Tax size
0
Laffer curve

The Laffer curve and supply-side economics
1974, economist Arthur Laffer
Laffer curve
Supply-side economics
Tax rates were so high that reducing them would actually raise tax revenue
Ronald Reagan’s experience in film industry
High tax rates caused less work
Low tax rates caused more work
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The Laffer curve and supply-side economics
Ronald Reagan ran for president in 1980
Platform: cutting taxes
Argument
Taxes were so high that they were discouraging hard work
Lower taxes would give people the proper incentive to work
Raise economic well-being
Perhaps increase tax revenue
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The Laffer curve and supply-side economics
Economists
Continue to debate Laffer’s argument
No consensus about the size of the relevant elasticities
General lesson:
Change in tax revenue from a tax change depends on how the tax change affects people’s behavior
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ASK THE EXPERTS
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The Laffer Curve
“A cut in federal income tax rates in the United States right now would lead to higher national income within five years than without the tax cut.”

Source: IGM Economic Experts Panel, June 26, 2012.
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ASK THE EXPERTS
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The Laffer Curve
“A cut in federal income tax rates in the United States right now would raise taxable income enough so that the annual total tax revenue would be higher within five years than without the tax cut.”