Effects of Taxes on a Market: Videos & Practice Problems

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 benefits that consumers experience due to the tax.

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

$\mathrm{Tax} \mathrm{Revenue}=\mathrm{Tax} \mathrm{Amount} \times \mathrm{Quantity}$

This product gives the total tax revenue collected by the government. On a graph, this is represented by the area of a rectangle formed by the tax amount (vertical distance) and the quantity sold (horizontal distance).

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 fewer transactions. This reduction in the quantity traded results in a loss of total surplus, which is the sum of consumer and producer surplus. The deadweight loss is represented by the area of the triangle formed between the supply and demand curves at the reduced quantity. It signifies the trades that no longer occur due to the tax, leading to a loss of potential gains from trade.

A tax reduces producer surplus, which 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. 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 represents the loss of benefits that producers experience due to the tax, as they receive less revenue for their goods.

Tax revenue is part of the total economic surplus, which includes consumer surplus, producer surplus, and tax revenue. When a tax is imposed, some of the consumer and producer surplus is transferred to the government as tax revenue. However, the total economic surplus decreases because the tax creates a deadweight loss, representing the surplus lost from trades that do not occur. Thus, while tax revenue increases, the overall economic surplus is reduced due to the inefficiencies introduced by the tax.