Chapter 8: Application: The Costs of Taxation

Question 1

Define ‘Deadweight loss’.

Answer 1

The fall in total surplus that results from a market distortion, such as a tax

Question 2

A tax on a good ___ the welfare of buyers and sellers of the good, and the reduction in consumer and producer surplus usually ___ the revenue raised by the government.

Answer 2

Reduces and exceeds.

Question 3

Why do taxes have deadweight losses?

Answer 3

They cause buyers to consume less and sellers to produce less, and this change in behaviour shrinks the market below the level that maximizes total surplus.

Question 4

Does a smaller or larger elasticity lead to a larger deadweight loss?

Answer 4

Because the elasticities of supply and demand measure how much market participants respond to market conditions, larger elasticities imply larger deadweight losses.

Question 5

What happens to deadweight loss and tax revenue as a tax grows larger?

Answer 5

As a tax grows, 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 the tax, but if the tax gets large enough, tax revenue starts to fall (Laffer Curve).