WEBVTT

00:00:00.000 --> 00:00:02.919
♪ [music] ♪

00:00:08.170 --> 00:00:10.440
- [Prof. Alex Tabarrok]
So far in our videos,

00:00:10.440 --> 00:00:13.710
we've looked at the effect
of taxes on market prices,

00:00:13.710 --> 00:00:15.130
but we haven't said much

00:00:15.130 --> 00:00:18.100
about why government levies taxes
in the first place,

00:00:18.100 --> 00:00:19.960
namely to get revenues.

00:00:19.960 --> 00:00:24.000
So let's look at that and also
at the cost of raising revenues,

00:00:24.000 --> 00:00:26.121
which is deadweight loss.

00:00:30.453 --> 00:00:32.620
We can show pretty much
everything we need to show

00:00:32.620 --> 00:00:34.260
with a single diagram.

00:00:34.260 --> 00:00:36.520
So here is our initial equilibrium.

00:00:36.520 --> 00:00:38.960
The price with no tax is $2

00:00:38.960 --> 00:00:43.420
and the quantity exchanged
with no tax is 700 units.

00:00:43.990 --> 00:00:47.050
Now, let's recall
that consumer surplus

00:00:47.050 --> 00:00:49.550
is the consumer's
gain from exchange,

00:00:49.550 --> 00:00:51.680
and it's this green area here,

00:00:51.680 --> 00:00:54.070
the area underneath the demand curve

00:00:54.070 --> 00:00:55.880
and above the price,

00:00:55.880 --> 00:00:58.500
up to the quantity exchanged.

00:00:58.500 --> 00:01:01.100
So it's the area
above the price of $2

00:01:01.100 --> 00:01:05.370
and up to the quantity exchanged
of 700 below the demand curve --

00:01:05.370 --> 00:01:07.250
this area right here.

00:01:07.250 --> 00:01:10.870
Producer surplus
is the producer's gain from exchange,

00:01:10.870 --> 00:01:13.050
and it’s the area
above the supply curve,

00:01:13.050 --> 00:01:16.020
up to the quantity exchanged
and below the price,

00:01:16.020 --> 00:01:17.860
below the producer's price.

00:01:18.210 --> 00:01:20.190
Now, you may also recall

00:01:20.190 --> 00:01:25.050
that a free market maximizes
consumer plus producer surplus.

00:01:25.050 --> 00:01:27.710
What we're going to show
is that when we have a tax,

00:01:27.710 --> 00:01:28.860
this is no longer true.

00:01:28.860 --> 00:01:30.630
The intervention
into the free market

00:01:30.630 --> 00:01:32.940
means that consumer
and producer surplus

00:01:32.940 --> 00:01:34.916
are not maximized.

00:01:34.916 --> 00:01:36.246
Let's take a look.

00:01:36.703 --> 00:01:39.533
So suppose we have tax of $1,

00:01:39.533 --> 00:01:42.040
and using our wedge method,

00:01:42.040 --> 00:01:45.870
we can find what the new price
is going to be for the buyers.

00:01:45.870 --> 00:01:47.180
It's going to be here.

00:01:47.180 --> 00:01:49.850
So the new price
for the buyers is say, $2.50.

00:01:50.560 --> 00:01:55.120
Notice now, the consumer surplus
is not this large green area

00:01:55.120 --> 00:02:00.050
since the price is now higher
and the quantity exchanged

00:02:00.050 --> 00:02:01.110
has fallen.

00:02:01.110 --> 00:02:05.990
The quantity exchanged
falls from 700 units to 500 units.

00:02:05.990 --> 00:02:08.960
So, the consumer surplus
with the tax

00:02:08.960 --> 00:02:13.030
is this smaller green area here.

00:02:13.030 --> 00:02:17.030
Again, it's the area
above the buyer's price,

00:02:17.030 --> 00:02:20.280
up to the quantity exchanged,
and below the demand.

00:02:20.280 --> 00:02:23.420
So exactly the definition
hasn't changed,

00:02:23.420 --> 00:02:26.830
but because of the tax
the price to the buyer changes,

00:02:26.830 --> 00:02:29.350
and the quantity demanded exchanges,

00:02:29.350 --> 00:02:31.590
so the consumer surplus
changes as well.

00:02:31.590 --> 00:02:33.710
In this case, it gets a lot smaller.

00:02:33.710 --> 00:02:35.610
What about producer surplus?

00:02:35.610 --> 00:02:40.840
Well, again, the price
which the sellers receive falls.

00:02:40.840 --> 00:02:44.650
So producer surplus is no longer
this large blue area,

00:02:44.650 --> 00:02:48.760
but is now just
this much smaller blue area.

00:02:48.760 --> 00:02:54.140
So the tax reduces consumer surplus
and it reduces producer surplus.

00:02:54.140 --> 00:02:56.060
Now, what about
this area in the middle?

00:02:56.060 --> 00:02:58.090
Well, fortunately,
that's not wasted.

00:02:58.090 --> 00:03:00.690
That, in fact, is tax revenues.

00:03:00.690 --> 00:03:05.440
So notice that the tax -- 
the height of the tax here -- is $1,

00:03:05.440 --> 00:03:08.460
and there are 500 units exchanged,

00:03:08.460 --> 00:03:13.138
so the government gets $1
for each of those 500 units.

00:03:13.138 --> 00:03:16.376
So this revenue,
tax revenue, is the area.

00:03:16.376 --> 00:03:20.356
It's the height
of this box times the width,

00:03:20.356 --> 00:03:24.430
and the height is the tax,
the width is the quantity exchanged.

00:03:24.430 --> 00:03:26.740
So this is tax revenue.

00:03:26.740 --> 00:03:29.766
Now, what about
this final bit over here?

00:03:29.766 --> 00:03:32.620
That used to be consumer
and producer surplus,

00:03:32.620 --> 00:03:35.900
but now it's deadweight loss.

00:03:35.900 --> 00:03:40.479
Nobody gets that.
That is lost gains from trade.

00:03:40.479 --> 00:03:43.999
So remember,
people used to trade 700 units.

00:03:43.999 --> 00:03:46.490
Now they're only trading 500 units.

00:03:46.490 --> 00:03:49.740
Those units
were benefitting people,

00:03:49.740 --> 00:03:51.370
but they're not anymore

00:03:51.370 --> 00:03:54.110
because these trades
are not occurring.

00:03:54.110 --> 00:03:56.350
I'm going to explain that
in a little bit more detail

00:03:56.350 --> 00:03:58.210
in the next slide.

00:03:59.400 --> 00:04:00.880
For now, just be sure
that you understand

00:04:00.880 --> 00:04:03.880
how to label these areas.

00:04:03.880 --> 00:04:06.910
So this is the new consumer surplus,

00:04:06.910 --> 00:04:09.910
tax revenues,
the new producer surplus,

00:04:09.910 --> 00:04:12.530
and this area is deadweight loss.

00:04:12.530 --> 00:04:15.530
Okay, let's explain deadweight loss
in a little bit more detail.

00:04:15.530 --> 00:04:19.899
Here's the way
to think about deadweight loss.

00:04:20.079 --> 00:04:21.079
Suppose that you're planning
a trip to New York

00:04:21.079 --> 00:04:23.850
and you're going to take the bus.

00:04:23.850 --> 00:04:28.470
The benefit of the trip to you,

00:04:28.650 --> 00:04:30.552
the value of seeing
the sights in New York is $50.

00:04:30.552 --> 00:04:32.454
The cost of the bus ticket is $40.

00:04:32.454 --> 00:04:34.357
So do you take the trip?
Is it a value?

00:04:34.357 --> 00:04:36.580
Yes, you take the trip.

00:04:36.580 --> 00:04:37.580
The total value of the trip is $10,
it's a positive,

00:04:37.580 --> 00:04:39.580
so you decide to take the trip.

00:04:39.580 --> 00:04:41.240
Trips is equal to one.
You make the trip.

00:04:41.240 --> 00:04:44.240
Okay, no problem.

00:04:44.240 --> 00:04:51.870
Now, suppose there's a tax
of $20 on bus fares

00:04:52.050 --> 00:04:53.050
and let's suppose
that raises the cost of the trip

00:04:53.050 --> 00:04:54.760
from $40 to $60.

00:04:54.760 --> 00:04:55.760
It doesn't have to raise it
by exactly that amount,

00:04:55.760 --> 00:04:57.760
by exactly the $20,
but let's suppose it does.

00:04:57.760 --> 00:05:03.530
Okay, so the cost
of the trip is now $60.

00:05:03.710 --> 00:05:08.980
The benefit is still $50.

00:05:08.980 --> 00:05:09.980
So do you take the trip? No.

00:05:09.980 --> 00:05:11.980
The benefit is less than the cost.

00:05:11.980 --> 00:05:16.930
So now, no trip.
Trips are equal to zero.

00:05:16.930 --> 00:05:17.930
Does the government
raise any revenue from you?

00:05:17.930 --> 00:05:19.930
No.

00:05:19.930 --> 00:05:25.010
Since you don't take the trip,
the government makes no revenue.

00:05:25.190 --> 00:05:28.590
Is there a deadweight loss?
Yes.

00:05:28.590 --> 00:05:31.590
You have lost
the value of the trip.

00:05:31.590 --> 00:05:36.160
You used to, when there was no tax,
you took the trip, it was worth $10,

00:05:36.340 --> 00:05:42.370
so the world was better off
by that $10 of value.

00:05:42.550 --> 00:05:47.130
Now with the tax,
you don't take the trip,

00:05:47.130 --> 00:05:48.130
so that $10 is a deadweight loss.

00:05:48.130 --> 00:05:50.130
It's gone. And notice that it's
not made up for by revenue.

00:05:50.130 --> 00:05:55.880
There's no revenue.

00:05:55.880 --> 00:05:58.880
So deadweight loss
is the value of the trips not made

00:05:58.880 --> 00:06:00.410
because of the tax,

00:06:00.410 --> 00:06:03.410
and there's no revenue
on trips which aren't made.

00:06:03.410 --> 00:06:05.130
Government only makes revenue

00:06:05.130 --> 00:06:08.130
on the trips
which continue to occur.

00:06:08.130 --> 00:06:11.200
So deadweight loss

00:06:11.200 --> 00:06:14.200
is the value of the trips
not made because of the tax.

00:06:14.200 --> 00:06:16.710
Now, to return this
to a more general case,

00:06:16.710 --> 00:06:19.710
instead of trips,
let's just replace that with trades.

00:06:19.710 --> 00:06:23.760
Deadweight loss

00:06:23.760 --> 00:06:26.760
is the value of the trades not made
because of the tax.

00:06:26.760 --> 00:06:32.800
Very quickly,
here's our diagram again.

00:06:32.980 --> 00:06:37.560
Before the tax,
there were 700 trades.

00:06:37.560 --> 00:06:38.560
After the tax,
there were 500 trades.

00:06:38.560 --> 00:06:41.390
So these are the 200 trades
which are not made

00:06:41.390 --> 00:06:44.220
because of the tax.

00:06:44.220 --> 00:06:45.220
And the value
of those 200 trades occurs

00:06:45.220 --> 00:06:47.230
because for these trades,

00:06:47.230 --> 00:06:51.700
the demanders value them

00:06:51.700 --> 00:06:54.700
more than it costs the suppliers
to provide those trades.

00:06:54.700 --> 00:06:59.120
So the demanders value the trades
as given by the demand curve,

00:06:59.300 --> 00:07:02.110
the height of the demand curve,

00:07:02.110 --> 00:07:05.110
the suppliers are willing
to supply those trades,

00:07:05.110 --> 00:07:09.440
the cost to them is given
by the height of the supply curve,

00:07:09.440 --> 00:07:12.440
so the value,
the value minus the costs,

00:07:12.440 --> 00:07:16.520
if you like, is given by this triangle.

00:07:16.520 --> 00:07:19.520
Because those trades
no longer occur,

00:07:19.520 --> 00:07:24.510
that value is no longer produced,
that's deadweight loss,

00:07:24.690 --> 00:07:27.360
the value of the trades
which don't occur because of the tax.

00:07:27.360 --> 00:07:30.360
Here's one more important point
about deadweight loss.

00:07:30.360 --> 00:07:32.390
Deadweight losses are larger

00:07:32.390 --> 00:07:35.390
the more elastic the demand curve
holding revenues constant.

00:07:35.390 --> 00:07:41.470
So for example, which of these
goods would we more like to tax --

00:07:41.650 --> 00:07:46.460
the one on the left
where the demand curve is elastic

00:07:46.640 --> 00:07:47.640
or the one on the right

00:07:47.640 --> 00:07:49.360
where the demand curve
is more inelastic?

00:07:49.360 --> 00:07:52.360
Notice that tax revenues
are the same.

00:07:52.360 --> 00:07:56.890
So if we have a choice,
which good do we want to tax?

00:07:57.070 --> 00:07:59.280
Well, pretty clearly, we want to tax
the good with the inelastic demand

00:07:59.280 --> 00:08:02.280
because the deadweight losses,
the lost gains from trade,

00:08:02.280 --> 00:08:05.910
are much smaller over here
than they are over here.

00:08:06.090 --> 00:08:11.810
So the tax on the good
with the elastic demand --

00:08:11.990 --> 00:08:13.780
it's creating a lot of waste
in order to get this revenue.

00:08:13.780 --> 00:08:16.780
Over here, the tax on the good
with the inelastic demand --

00:08:16.780 --> 00:08:22.240
there's only a little bit of waste
for the same amount of revenue.

00:08:22.420 --> 00:08:26.030
The intuition here is pretty simple.

00:08:26.030 --> 00:08:29.030
If the demand curve is inelastic,
then a tax won't deter many trades.

00:08:29.030 --> 00:08:30.580
And that's what we don't want.

00:08:30.580 --> 00:08:33.580
We don't want
to deter a lot of trades,

00:08:33.580 --> 00:08:38.010
because it's the lost gains
from trade

00:08:38.010 --> 00:08:41.010
which create the problem.

00:08:41.010 --> 00:08:45.100
We don't get any tax revenue
when we deter a trade.

00:08:45.100 --> 00:08:48.100
There's no tax revenue
when you deter an exchange.

00:08:48.100 --> 00:08:50.240
So we want to make sure

00:08:50.240 --> 00:08:53.240
that we deter
as few exchanges as possible

00:08:53.240 --> 00:08:55.740
and that will maximize our revenue
compared to our loss.

00:08:55.740 --> 00:08:58.740
Now, sometimes economists
are laughed at or derided

00:08:58.740 --> 00:09:03.340
because this implies, for example,
that you ought to tax insulin,

00:09:03.520 --> 00:09:08.590
a good with a very inelastic demand.

00:09:08.770 --> 00:09:10.070
Now, there are many reasons

00:09:10.070 --> 00:09:11.070
for taxing some goods
and not other goods,

00:09:11.070 --> 00:09:13.070
depending upon
who uses the insulin,

00:09:13.070 --> 00:09:16.850
whether it's poor people
or rich people

00:09:16.850 --> 00:09:19.850
or how important
health is and so forth.

00:09:19.850 --> 00:09:22.650
Nevertheless, as a general rule,

00:09:22.650 --> 00:09:25.650
it is better to tax goods
with an inelastic demand

00:09:25.650 --> 00:09:28.210
than goods with an elastic demand.

00:09:28.210 --> 00:09:29.210
That's important,

00:09:29.210 --> 00:09:31.210
and let me give you
an illustration of that.

00:09:31.210 --> 00:09:32.210
Here's something

00:09:32.210 --> 00:09:34.410
which you might think
would be a good idea to tax ---

00:09:34.410 --> 00:09:35.460
luxury yachts.

00:09:35.460 --> 00:09:36.460
They're only bought by the rich,

00:09:36.460 --> 00:09:38.460
so you're not really
harming people very much, right?

00:09:38.460 --> 00:09:41.620
Well, maybe so.

00:09:41.620 --> 00:09:42.620
However, in 1990,

00:09:42.620 --> 00:09:44.620
the federal government
actually applied a 10% luxury tax

00:09:44.620 --> 00:09:49.860
to many luxury goods,
including pleasure boats or yachts

00:09:50.040 --> 00:09:53.740
with a sales price above $100,000.

00:09:53.740 --> 00:09:56.740
They expected tax revenue
of $31 million.

00:09:56.740 --> 00:09:59.180
The reality, however,
was quite different.

00:09:59.180 --> 00:10:02.180
The tax revenues
were only $16.6 million.

00:10:02.180 --> 00:10:05.400
That was because sales of yachts
fell tremendously.

00:10:05.400 --> 00:10:08.400
Perhaps the yacht buyers decided,

00:10:08.400 --> 00:10:11.660
well, they could wait a year or two
before buying their yacht,

00:10:11.840 --> 00:10:13.210
see what happens.

00:10:13.210 --> 00:10:14.210
Or maybe they decided

00:10:14.210 --> 00:10:16.210
they could buy their yachts
in other countries.

00:10:16.210 --> 00:10:17.620
Yachts are pretty easy
to move around the world.

00:10:17.620 --> 00:10:20.620
After all, that's what they're for.

00:10:20.620 --> 00:10:24.650
The net result, in fact,

00:10:24.650 --> 00:10:27.650
was a loss of 7,000 jobs
in the yacht industry.

00:10:27.650 --> 00:10:29.500
Indeed, the federal government
ended up paying out more

00:10:29.500 --> 00:10:32.500
in unemployment benefits
to unemployed yacht workers

00:10:32.500 --> 00:10:39.790
than it collected
in tax revenues from yachts.

00:10:39.970 --> 00:10:45.860
Because of this, the federal tax
was repealed in 1993.

00:10:46.040 --> 00:10:47.270
The lesson here --

00:10:47.270 --> 00:10:48.270
don't tax goods
which have really elastic demands.

00:10:48.270 --> 00:10:50.270
You're not going to get
a lot of revenue,

00:10:50.270 --> 00:10:51.620
you're going to deter
a lot of trades,

00:10:51.620 --> 00:10:54.620
and that will create
a lot of deadweight loss,

00:10:54.620 --> 00:10:56.410
and perhaps,
secondary losses for other people,

00:10:56.410 --> 00:10:59.410
such as the workers.

00:10:59.410 --> 00:11:01.610
That's it actually for taxes.

00:11:01.610 --> 00:11:04.610
The only thing
we have left to do is subsidies.

00:11:04.610 --> 00:11:06.370
We can actually do that
in the next lecture pretty quickly

00:11:06.370 --> 00:11:09.370
because subsidies
are just negative taxes.

00:11:09.370 --> 00:11:11.400
So everything
we've said about taxes,

00:11:11.400 --> 00:11:14.400
with just a few changes
to our language,

00:11:14.400 --> 00:11:15.400
will go through
with subsidies as well.

00:11:15.400 --> 00:11:16.830
Thanks.

00:11:16.830 --> 00:11:20.070
- [Narrator]
If you want to test yourself,

00:11:20.070 --> 00:11:23.070
click “Practice Questions.”

00:11:23.070 --> 00:11:25.778
Or, if you're ready to move on,
just click “Next Video.”

00:11:26.304 --> 00:11:28.400
♪ [music] ♪