Effects of Taxes on a Market - Online Tutor, Practice Problems & Exam Prep

When a tax is imposed, it generates tax revenue calculated as the per unit tax multiplied by the quantity exchanged. This leads to a loss of economic surplus, creating a deadweight loss due to trades not occurring at equilibrium. Consumer surplus decreases, while producer surplus is also reduced, with some surplus transferred to tax revenue. The total economic surplus includes tax revenue but loses portions of consumer and producer surplus, highlighting the inefficiencies introduced by taxation in the market.

Effects of Taxes

Now let's talk about some of the effects on the market when there's a tax imposed. So the first thing we're going to see is that when there's a tax imposed, there's going to be tax revenue, right? The government is going to collect some amount of tax revenue. And we're going to be able to calculate that pretty easily, right? Because we're talking about per unit taxes, right? So for each unit that's sold, there's going to be a tax. So we're going to calculate our tax revenue as follows: the amount of the tax, which is the per unit tax, times the quantity exchanged at the taxable rate, represented as QT.

The tax revenue is going to be represented by a rectangle on the graph; this rectangle represents the tax and this represents the quantity where this is QT, the quantity with the tax. So, the calculation of tax revenue is going to be the amount of the tax times the quantity that is actually exchanged. You'll notice here, right, when we have this tax, we're not in equilibrium, right? The equilibrium was right here, and that's where we want to be, but now we have the situation where the price the buyer pays and the price the seller receives are different. We're not in equilibrium and there are trades that are not occurring because we're not at that equilibrium price. So, when the market is not in equilibrium, we lose some of our economic surplus. Remember economic surplus? That was the total of our consumer surplus and our producer surplus. We're going to see actually another part of surplus in this example. But when we lose economic surplus, we create what's called a deadweight loss.

Now, without a tax, when we're at equilibrium, the consumer surplus is going to be everything above the price but below the demand curve, which would include all of this area A, B, and C in our consumer surplus. For the producer surplus, it's going to be everything below the price and above the supply curve, which includes the areas D, E, and F. In this case, there's no tax, so there's no tax revenue. Our economic surplus is the sum of all of this which is A + B + C + D + E + F, and at equilibrium, we're maximizing that surplus.

With a tax, the situation changes. The consumer surplus is reduced to just area A, losing areas B + C due to the tax. Producer surplus is reduced to just F, losing D + E. The tax revenue, represented by the rectangle of area B + D, transfers part of the surplus from consumers and producers to the government. So, we calculate the economic surplus to include the tax revenue as well. Now it includes the areas A + B + D + F, losing C and E from our economic surplus. Lastly, the deadweight loss, which did not exist without a tax, is now represented by areas C + E, which indicates the surplus lost due to the tax impacting trading activities, preventing achieving the optimal trading quantity Q*.

If a tax has caused the market-clearing quantity to fall to Q2, what is consumer surplus?

• A. The area of (A)
• B. The area of (A), (B), and (C)
• C. The area of (A), (B), (C), (D), and (E)
• D. The area of (A), (B), (C), (D), (E), and (F)
• E. The area of (C) and (E)

If a tax has caused the market-clearing quantity to fall to Q2, what is total economic surplus?

• A. The area of (A) and (F)
• B. The area of (D), (E), and (F)
• C. The area of (A), (B), (D), and (F)
• D. The area of (A), (B), (C), (D), (E), and (F)
• E. The area of (C) and (E)

Here’s what students ask on this topic:

What is the effect of a tax on consumer surplus?

When a tax is imposed, consumer surplus decreases. Consumer surplus is the area above the price level and below the demand curve. With a tax, the price that consumers pay increases, reducing the area of consumer surplus. Specifically, the new consumer surplus is the area above the new higher price and below the demand curve, which is smaller than the original consumer surplus. This reduction in consumer surplus represents the loss of welfare for consumers due to the tax.

How is tax revenue calculated in a market with a tax?

Tax revenue is calculated by multiplying the per unit tax by the quantity of goods exchanged in the market. Mathematically, it can be represented as:

$\mathrm{Tax} \mathrm{Revenue}=\mathrm{Per} \mathrm{Unit} \mathrm{Tax} \times \mathrm{Quantity}$

This product gives the total tax revenue collected by the government. On a graph, this is represented by a rectangle where the height is the per unit tax and the width is the quantity exchanged.

What is deadweight loss and how does it occur due to a tax?

Deadweight loss is the loss of economic efficiency that occurs when the equilibrium for a good or service is not achieved. When a tax is imposed, it creates a wedge between the price buyers pay and the price sellers receive, leading to a reduction in the quantity traded. This reduction means that some mutually beneficial trades do not occur, resulting in a loss of total surplus. The deadweight loss is represented by the area of the triangle formed between the supply and demand curves at the reduced quantity.

How does a tax affect producer surplus?

When a tax is imposed, producer surplus decreases. Producer surplus is the area below the price level and above the supply curve. With a tax, the price that producers receive decreases, reducing the area of producer surplus. Specifically, the new producer surplus is the area below the new lower price and above the supply curve, which is smaller than the original producer surplus. This reduction in producer surplus represents the loss of welfare for producers due to the tax.

What happens to total economic surplus when a tax is imposed?

Total economic surplus, which includes consumer surplus, producer surplus, and tax revenue, decreases when a tax is imposed. Although tax revenue is added to the total surplus, the losses in consumer and producer surplus due to the tax are greater than the tax revenue gained. This results in a net loss of total economic surplus, which is represented by the deadweight loss. The deadweight loss indicates the inefficiency introduced by the tax, as it prevents some mutually beneficial trades from occurring.