Changes in Welfare
We can now see the effects of the tax by comparing welfare before and after the tax is enacted The third column in the table in Figure 3 shows the changes. The tax causes consumer surplus to fall by the area B + C and producer surplus to fall by the area D + E. Tax revenue rises by the area B + D. Not surprisingly, the tax makes buyers ~d sellers worse off and the government better off.
Figure 3 How a Tax Affects Welfare
A tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E) Because the in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a dead weight loss (area C + E).
The change in total welfare includes the change in consumer surplus (which IS negative), the change in producer surplus (which is also negative), and the change in tax revenue (which is positive) When we add these three pieces together, we find that total surplus in the market falls by the area C + E. Thus, the losses to buyers and sellers from a tax exceed the revenue raised by the government. The fall in total surplus that results when a tax (or some other policy) distorts a market outcome is called the dead weight loss. The area C + E measures the size of the dead weight loss. To understand why taxes impose dead weight losses, recall one of the Ten Principles of Economics in Chapter 1: People respond to incentives. In Chapter 7, we saw that markets normally allocate scarce resources efficiently. That is, the of supply and demand maximizes the total surplus of buyers and sellers in a market When a tax raises the price to buyers and lowers the price to sellers however, it. gives buyers an incentive to consume less and seller an incentive to produce less than they would in the absence of the tax. As buyers and sellers respond to these incentives, the size of the market shrinks below its optimum (as shown in the figure by the movement from Q to Q0. Thus, because taxes distort incentives they cause markets to allocate resources, inefficiently.
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