0:00:02.264,0:00:04.743 ♪ [music] ♪ 0:00:08.170,0:00:13.870 - So far in our videos, we've looked at[br]the effect of taxes on market prices, but 0:00:14.050,0:00:18.970 we haven't said much about why government[br]levies taxes in the first place, namely to 0:00:19.150,0:00:24.520 get revenues. So let's look at that and[br]also the cost of raising revenues, which 0:00:24.700,0:00:26.471 is deadweight loss. 0:00:30.743,0:00:33.124 We can show pretty much[br]everything we need to show with a 0:00:33.180,0:00:38.780 single diagram. So here is our initial[br]equilibrium. The price with no tax is $2 0:00:38.960,0:00:46.260 and the quantity exchanged with no tax is[br]700 units. Now, let's recall that consumer 0:00:46.440,0:00:52.000 surplus is the consumer's gain from[br]exchange, and it's this green area here, 0:00:52.180,0:00:57.560 the area underneath the demand curve and[br]above the price, up to the quantity 0:00:57.740,0:01:03.190 exchanged. So it's the area above the[br]price of $2 and up to the quantity 0:01:03.370,0:01:08.900 exchange of 700 below the demand curve,[br]this area right here. Producer surplus is 0:01:09.080,0:01:13.400 the producer's gain from exchange, and is[br]the area above the supply curve, up to the 0:01:13.580,0:01:19.270 quantity exchanged and below the price,[br]below the producer's price. Now, you may 0:01:19.450,0:01:25.660 also recall that a free market maximizes[br]consumer plus producer surplus. What we're 0:01:25.840,0:01:29.640 going to show is that when we have a tax,[br]this is no longer true. The intervention 0:01:29.820,0:01:35.110 into the free market means that consumer[br]and producer surplus are not maximized. 0:01:35.290,0:01:42.490 Let's take a look. So suppose we have tax[br]of $1, and using our wedge method, we can 0:01:42.670,0:01:47.590 find what the new price is going to be for[br]the buyers. It's going to be here. So the 0:01:47.770,0:01:53.410 new price for the buyer is say, $2.50.[br]Notice now, the consumer surplus is not 0:01:53.590,0:01:59.330 this large green area since the price is[br]now higher and the quantity exchanged has 0:01:59.510,0:02:03.780 fallen.[br]The quantity exchanged falls from 700 0:02:03.960,0:02:11.800 units to 500 units. So the consumer[br]surplus with the tax is this smaller green 0:02:11.980,0:02:17.950 area here. Again, it's the area above the[br]buyer's price, up to the quantity 0:02:18.130,0:02:23.880 exchanged, and below the demand. So[br]exactly the definition hasn't changed, but 0:02:24.060,0:02:28.540 because of the tax, the price of the buyer[br]changes, and the quantity demanded 0:02:28.720,0:02:32.530 exchanges, so the consumer surplus changes[br]as well. In this case, it gets a lot 0:02:32.710,0:02:39.070 smaller. What about producer surplus?[br]Well, again, the price which the sellers 0:02:39.250,0:02:45.300 receive falls. So producer surplus is no[br]longer this large blue area, but is now 0:02:45.480,0:02:52.080 just this much smaller blue area. So the[br]tax reduces consumer surplus and it 0:02:52.260,0:02:56.520 reduces producer surplus. Now, what about[br]this area in the middle? Well, 0:02:56.700,0:03:02.180 fortunately, that's not wasted. That, in[br]fact, is tax revenues. So notice that the 0:03:02.360,0:03:09.360 tax, the height of the tax here is $1 and[br]there are 500 units exchanged, so the 0:03:09.540,0:03:15.838 government gets $1 for each of those 500[br]units. So this revenue, tax revenue is the 0:03:15.838,0:03:22.816 area. It's the height of this box times[br]the width, and the height is the tax, the 0:03:22.816,0:03:28.396 width is the quantity exchanged. So this[br]is tax revenue. Now, what about this final 0:03:28.500,0:03:34.316 bit over here? That used to be consumer[br]and producer surplus, but now it's 0:03:34.316,0:03:41.999 deadweight loss. Nobody gets that. That is[br]lost gains from trade. So remember, people 0:03:42.100,0:03:48.619 used to trade 700 units, now they're only[br]trading 500 units. Those units were 0:03:48.700,0:03:54.512 benefiting people, but they're not anymore[br]because these trades are not occurring. 0:03:54.600,0:03:59.252 I'm going to explain that in a little bit[br]more detail in the next slide. For now, 0:03:59.400,0:04:03.700 just be sure that you understand how to[br]label these areas. 0:04:03.880,0:04:09.730 So this is the new consumer surplus, tax[br]revenues, the new producer surplus, and 0:04:09.910,0:04:15.350 this area is deadweight loss. Okay, let's[br]explain deadweight loss in a little bit 0:04:15.530,0:04:19.899 more detail. Here's the way to think about[br]deadweight loss. Suppose that you're 0:04:20.079,0:04:23.670 planning a trip to New York and you're[br]going to take the bus. The benefit of the 0:04:23.850,0:04:28.470 trip to you, the value of seeing the[br]sights in New York is $50, the cost of the 0:04:28.650,0:04:30.206 bus ticket is $40. 0:04:30.206,0:04:34.357 So do you take the trip?[br]Is it a value? Yes, you take the trip. The 0:04:34.357,0:04:39.400 total value of the trip is $10, it's a[br]positive, so you decide to take the trip. 0:04:39.580,0:04:44.060 Trips is equal to one. You make the trip.[br]Okay, no problem. Now, suppose there's a 0:04:44.240,0:04:51.870 tax of $20 on bus fares and let's suppose[br]that raises the cost of the trip from $40 0:04:52.050,0:04:57.580 to $60. It doesn't have to raise it by[br]exactly that amount, by exactly the $20, 0:04:57.760,0:05:03.530 but let's suppose it does. Okay, so the[br]cost of the trip is now $60. The benefit 0:05:03.710,0:05:11.800 is still $50. So do you take the trip? No.[br]The benefit is less than the cost. So now, 0:05:11.980,0:05:19.750 no trip. Trips are equal to zero. Does the[br]government raise any revenue from you? No. 0:05:19.930,0:05:25.010 Since you don't take the trip, the[br]government makes no revenue. Is there a 0:05:25.190,0:05:31.410 deadweight loss? Yes. You have lost the[br]value of the trip. You used to, when there 0:05:31.590,0:05:36.160 was no tax, you took the trip, it was[br]worth $10, so the world was better off by 0:05:36.340,0:05:42.370 that $10 of value. Now with the tax, you[br]don't take the trip, so that $10 is a 0:05:42.550,0:05:49.950 deadweight loss. It's gone. And notice[br]that it's not made up for by revenue. 0:05:50.130,0:05:58.700 There's no revenue. So deadweight loss is[br]the value of the trips not made because of 0:05:58.880,0:06:03.230 the tax, and there's no revenue on trips[br]which aren't made. 0:06:03.410,0:06:07.950 Government only makes revenue on the trips[br]which continue to occur. So deadweight 0:06:08.130,0:06:14.020 loss is the value of the trips not made[br]because of the tax. Now, to return this to 0:06:14.200,0:06:19.530 a more general case, instead of trips,[br]let's just replace that with trades. 0:06:19.710,0:06:26.580 Deadweight loss is the value of the trades[br]not made because of the tax. Very quickly, 0:06:26.760,0:06:32.800 here's our diagram again. Before the tax,[br]there were 700 trades. After the tax, 0:06:32.980,0:06:40.380 there were 500 trades. So these are the[br]200 trades which are not made because of 0:06:40.560,0:06:47.050 the tax. And the value of those 200 trades[br]occurs because for these trades, the 0:06:47.230,0:06:54.520 demanders value them more than it costs[br]the suppliers to provide those trades. So 0:06:54.700,0:06:59.120 the demanders value the trades as given by[br]the demand curve, the height of the demand 0:06:59.300,0:07:04.930 curve, the suppliers are willing to supply[br]those trades, the cost to them is given by 0:07:05.110,0:07:12.260 the height of the supply curve, so the[br]value, the value minus the cost, if you 0:07:12.440,0:07:19.340 like, is given by this triangle. Because[br]those trades no longer occur, that value 0:07:19.520,0:07:24.510 is no longer produced, that's deadweight[br]loss, the value of the trades which don't 0:07:24.690,0:07:30.180 occur because of the tax. Here's one more[br]important point about deadweight loss. 0:07:30.360,0:07:35.210 Deadweight losses are larger the more[br]elastic the demand curve holding revenues 0:07:35.390,0:07:41.470 constant. So for example, which of these[br]goods would we more like to tax, the one 0:07:41.650,0:07:46.460 on the left where the demand curve is[br]elastic or the one on the right where the 0:07:46.640,0:07:52.180 demand curve is more inelastic? Notice[br]that tax revenues are the same. So if we 0:07:52.360,0:07:56.890 have a choice, which good do we wanna tax?[br]Well, pretty clearly, we wanna tax the 0:07:57.070,0:08:02.100 good with the inelastic demand because the[br]deadweight losses, the lost gains from 0:08:02.280,0:08:05.910 trade, are much smaller over here than[br]they are over here. 0:08:06.090,0:08:11.810 So the tax on the good with the elastic[br]demand, it's creating a lot of waste in 0:08:11.990,0:08:16.600 order to get this revenue. Over here, the[br]tax on the good with the inelastic demand, 0:08:16.780,0:08:22.240 there's only a little bit of waste for the[br]same amount of revenue. The intuition here 0:08:22.420,0:08:28.850 is pretty simple. If the demand curve is[br]inelastic, then a tax won't deter many 0:08:29.030,0:08:33.400 trades. And that's what we don't want. We[br]don't want to deter a lot of trades 0:08:33.580,0:08:40.830 because it's the lost gains from trade[br]which create the problem. We don't get any 0:08:41.010,0:08:47.920 tax revenue when we deter a trade. There's[br]no tax revenue when you deter an exchange. 0:08:48.100,0:08:53.060 So we want to make sure that we deter as[br]few exchanges as possible and that will 0:08:53.240,0:08:58.560 maximize our revenue compared to our loss.[br]Now, sometimes economists are laughed at 0:08:58.740,0:09:03.340 or derided because this implies, for[br]example, that you ought to tax insulin, a 0:09:03.520,0:09:08.590 good with a very inelastic demand. Now,[br]there are many reasons for taxing some 0:09:08.770,0:09:12.890 goods and not other goods, depending upon[br]who uses the insulin, whether it's poor 0:09:13.070,0:09:19.670 people or rich people or how important[br]health is and so forth. Nevertheless, as a 0:09:19.850,0:09:25.470 general rule, it is better to tax goods[br]with an inelastic demand than goods with 0:09:25.650,0:09:31.030 an elastic demand. That's important, and[br]let me give you an illustration of that. 0:09:31.210,0:09:34.230 Here's something which you might think[br]would be a good idea to tax, luxury 0:09:34.410,0:09:38.280 yachts. They're only bought by the rich,[br]so you're not really harming people very 0:09:38.460,0:09:44.440 much, right? Well, maybe so. However, in[br]1990, the federal government actually 0:09:44.620,0:09:49.860 applied a 10% luxury tax to many luxury[br]goods, including pleasure boats or yachts 0:09:50.040,0:09:56.560 with a sales price above $100,000, the[br]expected tax revenue of $31 million. The 0:09:56.740,0:10:02.000 reality, however, was quite different. The[br]tax revenues were only $16.6 million. 0:10:02.180,0:10:08.220 That was because sales of yachts fell[br]tremendously. Perhaps the yacht buyers 0:10:08.400,0:10:11.660 decided, well, they could wait a year or[br]two before buying their yacht, see what 0:10:11.840,0:10:16.030 happens, or maybe they decided they could[br]buy their yachts in other countries. 0:10:16.210,0:10:20.440 Yachts are pretty easy to move around the[br]world. After all, that's what they're for. 0:10:20.620,0:10:27.470 The net result, in fact, was a loss of[br]7,000 jobs in the yacht industry. Indeed, 0:10:27.650,0:10:32.320 the federal government ended up paying[br]out more in unemployment benefits to 0:10:32.500,0:10:39.790 unemployed yacht workers than it collected[br]in tax revenues from yachts. Because of 0:10:39.970,0:10:45.860 this, the federal tax was repealed in[br]1993. The lesson here, don't tax goods 0:10:46.040,0:10:50.090 which have really elastic demands.[br]You're not going to get a lot of revenue, 0:10:50.270,0:10:54.440 you're going to deter a lot of trades, and[br]that will create a lot of deadweight loss, 0:10:54.620,0:10:59.230 and perhaps, secondary losses for other[br]people, such as the workers. That's it 0:10:59.410,0:11:04.430 actually for taxes. The only thing we have[br]left to do is subsidies. We can actually 0:11:04.610,0:11:09.190 do that in the next lecture pretty quickly[br]because subsidies are just negative taxes. 0:11:09.370,0:11:14.220 So everything we've said about taxes, with[br]just a few changes to our language, will 0:11:14.400,0:11:16.650 go through with subsidies as well. Thanks. 0:11:16.830,0:11:22.890 - If you want to test yourself, click[br]Practice Questions. Or if you're ready 0:11:23.070,0:11:25.778 to move on, just click Next Video. 0:11:26.304,0:11:28.400 ♪ [music] ♪