In this chapter you will examine how taxes reduce consumer and producer surplus, learn the meaning and causes of the deadweight loss of a tax, consider why some taxes have larger deadweight losses than others, examine how tax revenue and deadweight loss vary with the size of a tax. | 8 Application: The Costs of Taxation Application: The Costs of Taxation Welfare economics is the study of how the allocation of resources affects economic well-being. Buyers and sellers receive benefits from taking part in the market. The equilibrium in a market maximizes the total welfare of buyers and sellers. THE DEADWEIGHT LOSS OF TAXATION How do taxes affect the economic well-being of market participants? THE DEADWEIGHT LOSS OF TAXATION It does not matter whether a tax on a good is levied on buyers or sellers of the good . . . the price paid by buyers rises, and the price received by sellers falls. Figure 1 The Effects of a Tax Copyright © 2004 South-Western Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax How a Tax Affects Market Participants A tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the . | 8 Application: The Costs of Taxation Application: The Costs of Taxation Welfare economics is the study of how the allocation of resources affects economic well-being. Buyers and sellers receive benefits from taking part in the market. The equilibrium in a market maximizes the total welfare of buyers and sellers. THE DEADWEIGHT LOSS OF TAXATION How do taxes affect the economic well-being of market participants? THE DEADWEIGHT LOSS OF TAXATION It does not matter whether a tax on a good is levied on buyers or sellers of the good . . . the price paid by buyers rises, and the price received by sellers falls. Figure 1 The Effects of a Tax Copyright © 2004 South-Western Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax How a Tax Affects Market Participants A tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. The size of the market for that good shrinks. How a Tax Affects Market Participants Tax Revenue T = the size of the tax Q = the quantity of the good sold T Q = the government’s tax revenue Figure 2 Tax Revenue Copyright © 2004 South-Western Tax revenue (T × Q) Size of tax (T) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive Figure 3 How a Tax Effects Welfare Copyright © 2004 South-Western A F B D C E Quantity 0 Price Demand Supply = PB Q2 = PS Price buyers pay Price sellers receive = P1 Q1 Price without tax How a Tax Affects Market Participants Changes in Welfare A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax. How a Tax Affects Welfare How a Tax Affects Market Participants The change in total welfare includes: The change in consumer surplus, The change in producer surplus, and The change in tax revenue. The losses to .