Dead weight loss

Dead weight loss and Tax

Presented by-☺ Pooja goyal 13189☺ Pooja sharma 13190☺ Priyanka meena 13210☺ Pia singh 13186

Dead weight loss occurs when government imposes tax on commodity, and both producer and consumer loose part of their surplus, the loss suffers by both producer and consumer is dead weight loss.

TAX

Tax WedgeA 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.

Tax Revenue

Copyright © 2004 South-Western

Taxrevenue

(T × Q)

Size of tax (T)

Quantitysold (Q)

Quantity0

Price

Demand

Supply

Quantitywithout tax

Quantitywith tax

Price buyers

pay

Price sellersreceive

How a Tax Effects Welfare


A

F

B

D

C

E

Quantity0

Price

Demand

Supply

=PB

Q2

=PS

Pricebuyerspay

Pricesellersreceive

=P1

Q1

Pricewithout tax

Determinants of Deadweight Loss

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 elasticities of supply and demand.

Determinants of Deadweight LossThe greater the elasticities of

demand and supply:◦ the larger will be the decline in

equilibrium quantity and,◦ the greater the deadweight loss of a

tax.

Tax Distortions and Elasticities


(a) Inelastic Supply

Price

0 Quantity

Demand

Supply

Size of tax

When supply isrelatively inelastic,the deadweight lossof a tax is small.



(b) Elastic Supply

Price

0 Quantity

Demand

SupplySizeoftax

When supply is relativelyelastic, the deadweightloss of a tax is large.



Demand

Supply

(c) Inelastic Demand

Price

0 Quantity

Size of taxWhen demand isrelatively inelastic,the deadweight lossof a tax is small.



(d) Elastic Demand

Price

0 Quantity

Sizeoftax Demand

Supply

When demand is relativelyelastic, the deadweightloss of a tax is large.

Extreme casesIf demand were perfectly inelastic (a

vertical demand curve), the quantity demanded is unchanged by the imposition of the tax. As a result, the tax imposes no deadweight loss.

Similarly, if supply were perfectly inelastic (a vertical supply curve), the quantity supplied is unchanged by the tax and there is also no deadweight loss.

Deadweight Loss and Tax Rate

With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.

Tax Revenue and Tax RateFor the small tax, tax revenue is

small.As the size of the tax rises, tax

revenue grows.But as the size of the tax

continues to rise, tax revenue falls because the higher tax reduces the size of the market.

Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes


Tax revenue

Demand

Supply

Quantity0

Price

Q1

(a) Small Tax

Deadweightloss

PB

Q2

PS



Tax revenue

Quantity0

Price(b) Medium Tax

PB

Q2

PS

Supply

Demand

Q1

Deadweightloss



Tax

reve

nue

Demand

Supply

Quantity0

Price

Q1

(c) Large Tax

PB

Q2

PS

Deadweightloss

How Deadweight Loss and Tax Revenue Vary with the Size of a Tax


DeadweightLoss

0 Tax Size

How Deadweight Loss and Tax Revenue Vary with the Size of a Tax – Laffer curve


TaxRevenue

0 Tax Size

Laffer Curve The Laffer curve depicts the

relationship between tax rates and tax revenue.

Supply-side economics : refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues.

IN MONOPOLY

The Deadweight LossIn monopoly, firm sets its price

above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost.◦This wedge causes the quantity sold

to fall short of the social optimum.

The Inefficiency of Monopoly

Quantity0

PriceDeadweight

loss

DemandMarginalrevenue

Marginal cost

Efficientquantity

Monopolyprice

Monopolyquantity

The Deadweight LossThe deadweight loss caused by a

monopoly is similar to the deadweight loss caused by a tax.

The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit.

For reducing deadweight loss, in monopoly, price discrimination is use.

PRICE DISCRIMINATIONPrice discrimination is the

business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.

PRICE DISCRIMINATIONPrice discrimination is not possible when

a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power.

Perfect Price Discrimination◦Perfect price discrimination refers to the

situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.

PRICE DISCRIMINATIONTwo important effects of price

discrimination:◦It can increase the monopolist’s

profits.◦It can reduce deadweight loss.

Welfare with and without Price Discrimination


Profit

(a) Monopolist with Single Price

Price

0 Quantity

Deadweightloss

DemandMarginalrevenue

Consumersurplus

Quantity sold

Monopolyprice

Marginal cost

Welfare with and without Price Discrimination

Profit

(b) Monopolist with Perfect Price Discrimination

Price

0 Quantity

Demand

Marginal cost

Quantity sold

Estimating Dead Weight Loss Due to Imperfectly Competitive Market Structures

Economists are naturally interested in estimating the size of dead weight losses (DWLs) resulting from allocative inefficiency. Estimating DWL is difficult because the investigator will not normally know the true value of marginal cost. Hence, DWL must be estimated indirectly.

Harburger’s ApproachThe ABH dead weight triangle is approximated by the following equation (equation 4.1 in the text):

))((21

MCCM QQPPDWL

By algebraic manipulation it can be shown that:

**21 2 QPdDWL [1]

Explanation of equation is price elasticity of demand

d is the price cost margin, that is:

PMCPd

P* is the monopoly price

Q* is the monopoly output

•To estimate d, Harburger measured the difference between rate of return for the industry and the average rate of return for all industries. •Harburger assumed that, for all industries, = 1

Harburger’s estimates

Based on data for U.S. industries in the 1920s, Harburger estimated the DWL due to monopoly to be equal to 1/10 of 1 percent of GNP. Hence, the welfare loss due to pricing above marginal cost is very small and would hardly justify the allocation of substantial resources for antitrust enforcement.

Cowling and Mueller’s Approach

above reveals that estimates of DWL are sensitive to assumptions made about elasticity of demand ( )Cowling and Mueller made adjustments to the methodology used by Harburger and , using a sample of 734 U.S. firms for 1963-66, reached radically different conclusions as regards the magnitude of welfare losses.•Cowling and Mueller changed a key assumption of Harburger; namely, that for all industries, = 1.

To estimate industry-level price elasticities (), Cowling and Mueller took advantage of the fact that the firm’s profit maximizing price (P*) satisfies the following condition:

MCPP

** [2]

Recall that d is the price-cost margin . Thus we can say:

MCPP

d

**1 [3]

Thus by equation [2], we can say:

d1 Thus if you

can estimate d, you can estimate

Thus substitute 1/d for in equation [1] and you get:

**21**1

21 2 QdPQPd

dDWL

[4]

Substituting (P*- MC)/P* for d in equation [4] gives us:

*21*)*(

21***

21

QMCPQPP

MCPDWL [5]

Thus, Cowling and Mueller showed that DWL for an industry was equal to ½ of the economic profits () of firms in the industry.

Pric

e

Quantity0

PM

QM

MC

DMR

PC

QC

A

B

C

Figure 1

Pric

e

Quantity0

P*

Q*

MC

DMR

*21*)*(

21***

21

QMCPQPP

MCPDWL

•DWL is given by the black –shaded triangle.• is given by the green-shaded rectangle

Measuring Dead Weight Loss

Cowling and Mueller’s resultsAssuming that 12 percent is a "normal" rate of return on capital, Cowling and Mueller produced 2 estimates of DWL in the U.S. economy:• The low estimate, which does not include advertising expenditures as a component of the dead weight loss, was 4 percent of GNP (about $403 billion in 2001). • The high estimate, which reckoned advertising expenditures as "wasted resources," was 13 percent of GNP (about $1.394 trillion in 2001).

Economy & Finance

Dead weight loss