Quiz 8: Application: the Costs of Taxation



Price determination under perfect competition: Under perfect competition market, price and quantity is determined by the market forces where demand is equal to supply. a) Below diagram 1.1 shows the equilibrium price and quantity where demand is equal to supply. img In the above diagram, the equilibrium price shown as P and equilibrium quantity is shown as Q1. The area A+B+C is shown as consumer surplus, and the area D+E+F is shown as producer surplus. Total surplus area is under the area of ( A+B+C+D+E+F ), this means, there is no deadweight loss under the market. b) Suppose that the government forces each pizzeria to pay a $1 tax on each pizza sold, this will lead to decrease in the consumer surplus, and producer surplus. In the below diagram 1.2, it is shown that as price increases from P to Pc, which means consumers has to pay P C , thus, the area under consumer surplus will decrease. Whereas producer will receive P S and producer surplus will also decrease, here P C = P S + $1. img Now, the consumer surplus is A , and the producer surplus is F. Government revenue area is B+D , and the deadweight loss area is C+E. c) If the tax were removed, then the consumers and producers would be better off when some part is voluntarily transferred to the government. The equilibrium price is P and quantity is Q1 , as in the case without tax. Now, the consumer surplus area is A+B+C. Thus, the part B is voluntarily transferred to the government, and producer surplus is D+E+F. Thus, the part D is voluntarily transferred to the government. In the below graph 1.3, the red shaded area shows the consumer surplus, yellow shaded area shows the producer surplus, and gray shaded area shows government revenue. img If consumers and producers transfer a little bit more than B+D , then all the three parties will be better off. This situation is called inefficiency of taxation.

A tax on a good reduces the welfare of buyers and sellers. Because a tax on a good raises the price buyers pay and lowers the price sellers receive. So a tax on a good reduces consumer surplus (benefit for buyers) and producer surplus (benefit for sellers) Even though a tax on a good raises the revenue, there are losses to the buyers and sellers because of the tax which can exceed the revenue raised by the Government.