Deadweight Loss

The largest amount of revenue raised by governments come from taxation of market transactions,
especially the taxation of Labour. Taxes obviously lower the value of transaction to both buyers and
sellers in that the buyer pays somewhat more for the product and the supplier receives less. Some of
that loss of values go to the government, which of course, is why it collect taxes. However, it has
long been recognized that the loss of value to the market participants exceeds the gain to the
government. Therefore, the economy as a whole loses some value from taxation, a complete loss
called the dead weight loss of taxation. Specifically, did weight loss consists of the loss of consumer
surplus for buyers plus the loss of producer surplus for sellers do not participate in the market for
reasons other than the price of the product or services resulting in less total surplus for the
economy. Dead weight loss can also be created by artificial barriers to competitions such as
occupation licensing requirements or from the artificial restriction of supply by monopolists or
oligopolists.

Look at the supply and demand

curves in the graph. When a
market transaction is taxed, the
buyer pays a higher price, and
the seller receives a lower price.
This lowers demand, which
shifts the buyer's equilibrium
from the market price (Pm) to a
higher price (Pb) at lower
quantities; likewise, because the
seller receives a lower price (Ps)
for his product, less of it is
supplied, which moves the
seller's equilibrium down the
supply curve, to a lower price
and quantity. The amount the
government receives equals the
tax, which equals the buyer's
price minus the seller's price,
times the quantity of the
transaction, whether for goods
or services.

Tax Revenue = Tax × Quantity

The area of the light purple rectangle in the graph equals the tax revenue collected by the
government. The area of the dark purple triangle equals the economic welfare lost to taxation.

Pb = Price buyers pay. Demand is reduced because buyers must pay a higher price because of the
tax.

Pm = Market price without taxes.

Ps = Price sellers receive.

Qe = The quantity supplied without the tax.

Qt = The reduced quantity supplied because of the tax.

This loss of economic welfare consists of buyers who will no longer buy the product because the
price is higher than their willingness-to-pay price, so they decide to do without. Likewise, some
sellers will not produce a product because they are not receiving a high enough price to cover their
economic costs. The benefit that these buyers and sellers would have added to the economy but for
the tax is a deadweight loss of taxation. Because these buyers and sellers do not participate in the
market, they do not contribute to the tax, which is why the government does not receive the portion
consisting of the deadweight loss. Instead, the taxes are paid by the buyers and sellers who continue
to participate in the market. The buyers pay part of the tax, in an economic sense, as a reduction in
their consumer surplus, which is the difference between their willingness-to-pay price and the
product price. Likewise, sellers pay part of the tax as a reduction in their producer surplus. This loss,
however, goes to the government in the form of its tax, which makes sense, since only the buyers
that continue to buy the product and the sellers who continue to sell the product contribute to the
tax. Thus, in terms of total surplus (= consumer surplus + producer surplus), the deadweight loss
equals the reduction in total surplus minus the tax revenue collected by the government.

Deadweight Loss = Loss of Total Surplus – Tax Revenue

How Deadweight Loss Varies with Elasticity

The amount of the deadweight loss varies with both demand elasticity and supply elasticity. When
either demand or supply is inelastic, then the deadweight loss of taxation is smaller, because the
quantity bought or sold varies less with price. With perfect inelasticity, there is no deadweight loss.
However, deadweight loss increases proportionately to the elasticity of either supply or demand.
Who suffers the tax burden also depends on elasticity. When supply is inelastic or demand is elastic,
then the seller suffers the major tax burden, as can be seen in the orange-shaded areas in graphs #2
and #4, above; when supply is elastic or demand is inelastic, then the buyer pays most of the tax
(Graphs #1 and #3). Of course, the effect of elasticity on the tax is no different from its effect on any
other price change.

Tax revenue varies with the proportion of the tax as a percentage of the product price. Usually, a
moderate tax rate will yield the most tax revenue, as can be seen from the first diagram above.
When the tax rate is small or high, tax revenue will be less. When the tax rate is small, the
government only gets a small portion of the price paid. When the tax rate is high, then the quantity
sold is much less, so even when it is multiplied by the high tax rate, it yields less revenue, which can
be seen in the diagrams below. Also illustrated is that the deadweight loss of a high tax rate is much
greater than the deadweight loss of a low tax rate.
A high tax rate, as a low tax rate, yields little government revenue, but the high tax rate comes at a
bigger expense to the economy, since it reduces total surplus more: fewer people will be able to
enjoy the goods and services subject to the high tax rate.

Of course, this is desirable for excise taxes on goods or services that are detrimental to people or
society, such as tobacco and alcohol consumption. In this case, a high tax rate not only earns some
revenue for the government, but also promotes more desirable goals.

Deadweight Loss from Imperfect Competition

Deadweight loss also arises from imperfect competition, especially from oligopolies and monopolies.
This deadweight loss arises because these firms restrict supply to increase prices over and above
average total costs. The higher prices will still restrict some consumers from enjoying the product,
and as with the deadweight loss of taxation, it will reduce the consumer surplus of the remaining
buyers, but the restricted supply allows these firms to enjoy economic profits, profits that exceed
the normal profits included in average total costs. However, the additional revenue from the higher
prices goes not to the government, in the form of taxes, but to the price-setting firms, in the form of
additional producer surplus.

At e1

 CS = R+V
 PS = S+U+T
At e2

 CS = R+S
 PS = T

Transfer of S from producer to consumer

Dead Weight Loss (DWL) U+V (Net reduction in social welfare because of trade not made or
inefficiency)

Consumer Surplus = A+C

Producer Surplus = E

DWL = B+D

Costs of Government Intervention

1. Inefficiency or DWL (Efficiency loss)

2. Allocative inefficiency
a. Opportunity cost

Equity-efficiency trade-off

Scalpers