DEAD WEIGHT LOSSES AND THE GAINS FROM TRADE
To gain some intuition for why taxes result in dead weight losses, consider an example. Imagine that Joe cleans Jane’s house each week for $100. The opportunity cost of Joe’s time is $80, and the value of a clean house to Jane is $120. Thus, Joe and Jane each receive a $20 benefit from their deal. The total surplus of $40 measures the gains from trade in this particular transaction. Now suppose that the government levies a $50 tax on the providers of cleaning services. There is now no price that Jane can pay Joe that will leave both of them better off after paying the tax. The most Jane would be willing to pay is $120, but then Joe would be left with only $70 after paying the tax, which is less than his $80 opportunity cost. Conversely, for Joe to receive his opportunity cost of $80, Jane would need to pay $130, which is above the $120 value she places on a clean house. As a result, Jane and Joe cancel their arrangement. Joe goes without the income, and Jane lives in a dirtier house. The tax has made Joe and Jane worse off by a total of $40 because they have each lost $20 of surplus But note that the government collects no revenue from Joe and Jane because they decide to cancel their arrangement. The $40 is pure dead weight loss: It is a loss to’ buyers and sellers in a market that is not offset by an increase in government revenue. From this example, we can see the ultimate source of dead weight losses: Taxes cause dead weight losses because they prevent buyers and sellers from realizing some of the gains from trade. The area of the triangle between the supply and demand curves (area C + E in’ Figure 3) measures these losses. This conclusion can be seen more easily in Figure 4 by recalling that the demand curve reflects the value of the good to consumers and that the supply curve reflects the costs of producers. When the tax raises the price to buyers to Pa and lowers the price to sellers to Ps, the marginal buyers and sellers leave the market, so the quantity sold falls from QI to Q2. Yet as the figure shows, the value of the good to these buyers still exceeds the cost to these sellers. At every quantity between QI and Q2 the situation is the
Figure 4 The Dead weight Loss When the government imposes a tax on a good, the quantity sold falls from 01 to Oz. At every quantity between 01 and Oz. the potential gains from trade among buyers and sellers do not get realized These lost gains from trade create the dead weight loss.
same as in our example with Joe and Jane. The gains from trade-the difference between buyers’ value and sellers’ cost-are less than the tax. As a result, these trades do not get made once the tax is imposed The dead weight loss is the surplus lost because the tax discourages these mutually advantageous trades.
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