Deadweight loss of taxation

Presented by Group 3
Definition
A loss of economic well-being imposed by a tax.
Taxes lower the value of transactions to both buyers and
sellers, in that, to some extent, the buyer pays more for the
product and the supplier receives less.


Example of deadweight loss
Example
10% Entertainment duty on movie tickets
tickets priced between Rs.251 and Rs.350
from January 16, 2013.
P
Q
D
S
{
330

315

300
Example
When subsidy is provided by government ,the
total cost of subsidy exceeds the benefits enjoyed
by the consumers and sellers.

3 4
Seller receives
Equilibrium
Buyer pays
Pp
Pc
E
S1
S
D
P
Q
Pp= Price producer receives
Pc=Price consumer pays
What determines whether the deadweight loss from a tax is
large or small?
The magnitude of the deadweight loss depends on how much the
quantity supplied and quantity demanded respond to changes in the
price.
That, in turn, depends on the price elasticity of supply and demand.
The greater the elasticity of demand and supply:
the larger will be the decline in equilibrium quantity and,
the greater the deadweight loss of a tax.

Determinants of deadweight loss

Inelastic supply
Price
0 Quantity
Demand
Supply
Size of tax
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Inelastic Supply

Mumbai- Delhi
Flight base fare Rs 5,110
Flight taxes Rs 401
Price + tax ( price paid by fliers) Rs 5511
Supply= inelastic
Price
0 Quantity
Demand
Supply
Size
of
tax
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Elastic supply

Inelastic demand
Demand
Supply
Price
0 Quantity
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Inelastic Demand

Examples of inelastic demand

The government may choose to levy an excise tax on tobacco products to deal with the negative externality
of secondhand smoke.

This would raise the price of the tobacco products, driving a wedge between the price that buyers pay and
the revenue that sellers receive.

However, because this particular good is addictive and thus subject to habitual consumption, so demand is
relatively inelastic.
In other words, demand does not decrease much when the price increases.

Elastic demand
Price
0 Quantity
Size
of
tax
Demand
Supply
When demand is relatively
elastic, the deadweight
loss of a tax is large.
Elastic Demand

Elastic demand
Example of Elastic Demand

Greater deadweight in elastic demand
Example:
Suppose Rs1000 tax is levied on used cars and the no. of units
traded falls from 750 to 500. The imposition of the tax reduced the
units traded by 250 units.
The loss of the mutual benefit that would have been derived had the
tax not eliminated 250 units of exchange imposes a cost on the
buyers and sellers.
The cost is deadweight loss of the tax.

EXAMPLE OF ELASTIC DEMAND

Clothing has elastic demand. True, people have to wear clothes, but there are
many choices of what kind of clothing, and how much to spend.
Stores offered sales, and as a result clothing prices dropped to maintain
demand. Small stores that couldn't offer huge discounts went out of business.
During the Great Recession, they were replaced by second-hand stores that
offered quality used clothing at steeply discounted prices

Dead weight loss and tax revenue

Tax revenue is the income that is gained by governments through
taxation.
Tax revenue varies with the proportion of the tax as a percentage of
the product price.
Moderate tax rate= most tax revenue
Tax rate small= less tax revenue.
tax rate high= less tax revenue
Tax revenue
Demand
Supply
Quantity 0
Price
Q
1

Deadweight
loss
P
B

Q
2

P
S

Size of tax is small

Tax revenue
Quantity 0
Price
P
B

Q
2

P
S

Supply
Demand
Q
1

Deadweight
loss
Size of tax is medium

T
a
x

r
e
v
e
n
u
e

Demand
Supply
Quantity 0
Price
Q
1

P
B

Q
2

P
S

Deadweight
loss
Size of Tax is large

Deadweight vs tax size
Deadweight VS Tax size

Size of tax is small

Tax revenue vs tax size