[Apologies for the shonky graphs here – I used Paintbrush, badly. Does anybody know any good free graph-making software, perhaps?]
So here’s your supply and demand curves for some product, say petrol. This market is operating, we’re assuming, without taxation. The quantity supplied is Q1, the market price is P1.
And now the government imposes an excise tax on petrol.
The quantity of petrol supplied is reduced – moving to Q2. We can calculate government revenues from this tax by calculating the area of the rectangle A. Revenue = Q2(P3 – P2). Right? The deadweight loss from this tax is the area of the triangle B. Yes? There is a net loss of value from the imposition of the tax – there is less value in the economy after the tax that there was before, because government revenues are smaller than the total loss in consumer and producer surpluses (i.e. the area of A and B combined). This will always be the case. The smaller the elasticity of supply and demand, the smaller the deadweight loss – but there will always be a deadweight loss when taxation moves a market away from equilibrium. Taxation always creates economic inefficiency.
I’m glossing my textbook (Krugman, Wells and Graddy, 2007). But as far as I can tell, my textbook makes little sense. My response to the above is basically: WTF?! [Calculate the area of that triangle…]
Why are we here seeing the imposition of a tax as generating a movement away from equilibrium? Why aren’t we seeing a change in the supply and demand curves, as a result of the changing costs of producing/supplying/purchasing the product? Surely the new quantity of petrol supplied is the product of a new market equilibrium?
But no mention is made of a new market equilibrium in my textbook – rather, the situation post-taxation is presented as a deviation from equilibrium; a bad-news deviation from the optimal scenario of voluntary free exchange.
“Deadweight loss triangles are produced not only by excise taxes, but by other types of taxation. They are also produced by other kinds of distortions of markets, such as monopoly.” (p. 157.) “As a result [of taxation] some mutually beneficial trades between producers and consumers do not take place.” (p. 156).
But no. From the point of view of both consumers and producers, taxes are a cost like any other [well, not necessarily like any other – but they’re a cost]. You could re-run this entire scenario with some other cost instead of an excise tax – and this cost would also produce a ‘deadweight loss’ as it brought the market away from the equilibrium we’d see if there were no such cost. That doesn’t mean that we’re here (or anywhere) moving away from an efficient (equilibrium) market to an inefficient (distorted) one: it means only that the factors determining the supply and demand curves, and thus market equilibrium, have changed.
Why is taxation [and, later in the textbook, monopoly] singled out for special treatment? Why is this cost treated as external to and separable from movements of the supply and demand curves, while some other cost (an increase in the price of oil, say), is accepted as part of the normal functioning of the market?
‘Deadweight loss’ is everywhere. The supply and demand curves are created by deadweight loss.
Or am I getting everything wrong? (More than likely.)