0:00:00.000,0:00:02.919
♪ [music] ♪

0:00:08.170,0:00:10.440
- [Prof. Alex Tabarrok][br]So far in our videos,

0:00:10.440,0:00:13.710
we've looked at the effect[br]of taxes on market prices,

0:00:13.710,0:00:15.130
but we haven't said much

0:00:15.130,0:00:18.100
about why government levies taxes[br]in the first place,

0:00:18.100,0:00:19.960
namely to get revenues.

0:00:19.960,0:00:24.000
So let's look at that and also[br]at the cost of raising revenues,

0:00:24.000,0:00:26.121
which is deadweight loss.

0:00:30.453,0:00:32.620
We can show pretty much[br]everything we need to show

0:00:32.620,0:00:34.260
with a single diagram.

0:00:34.260,0:00:36.520
So here is our initial equilibrium.

0:00:36.520,0:00:38.960
The price with no tax is $2

0:00:38.960,0:00:43.420
and the quantity exchanged[br]with no tax is 700 units.

0:00:43.990,0:00:47.050
Now, let's recall[br]that consumer surplus

0:00:47.050,0:00:49.550
is the consumer's[br]gain from exchange,

0:00:49.550,0:00:51.680
and it's this green area here,

0:00:51.680,0:00:54.070
the area underneath the demand curve

0:00:54.070,0:00:55.880
and above the price,

0:00:55.880,0:00:58.500
up to the quantity exchanged.

0:00:58.500,0:01:01.100
So it's the area[br]above the price of $2

0:01:01.100,0:01:05.370
and up to the quantity exchanged[br]of 700 below the demand curve --

0:01:05.370,0:01:07.250
this area right here.

0:01:07.250,0:01:10.870
Producer surplus[br]is the producer's gain from exchange,

0:01:10.870,0:01:13.050
and it’s the area[br]above the supply curve,

0:01:13.050,0:01:16.020
up to the quantity exchanged[br]and below the price,

0:01:16.020,0:01:17.860
below the producer's price.

0:01:18.210,0:01:20.190
Now, you may also recall

0:01:20.190,0:01:25.050
that a free market maximizes[br]consumer plus producer surplus.

0:01:25.050,0:01:27.710
What we're going to show[br]is that when we have a tax,

0:01:27.710,0:01:28.860
this is no longer true.

0:01:28.860,0:01:30.630
The intervention[br]into the free market

0:01:30.630,0:01:32.940
means that consumer[br]and producer surplus

0:01:32.940,0:01:34.916
are not maximized.

0:01:34.916,0:01:36.246
Let's take a look.

0:01:36.703,0:01:39.533
So suppose we have tax of $1,

0:01:39.533,0:01:42.040
and using our wedge method,

0:01:42.040,0:01:45.870
we can find what the new price[br]is going to be for the buyers.

0:01:45.870,0:01:47.180
It's going to be here.

0:01:47.180,0:01:49.850
So the new price[br]for the buyers is say, $2.50.

0:01:50.560,0:01:55.120
Notice now, the consumer surplus[br]is not this large green area

0:01:55.120,0:02:00.050
since the price is now higher[br]and the quantity exchanged

0:02:00.050,0:02:01.110
has fallen.

0:02:01.110,0:02:05.990
The quantity exchanged[br]falls from 700 units to 500 units.

0:02:05.990,0:02:08.960
So, the consumer surplus[br]with the tax

0:02:08.960,0:02:13.030
is this smaller green area here.

0:02:13.030,0:02:17.030
Again, it's the area[br]above the buyer's price,

0:02:17.030,0:02:20.280
up to the quantity exchanged,[br]and below the demand.

0:02:20.280,0:02:23.420
So exactly the definition[br]hasn't changed,

0:02:23.420,0:02:26.830
but because of the tax[br]the price to the buyer changes,

0:02:26.830,0:02:29.350
and the quantity demanded exchanges,

0:02:29.350,0:02:31.590
so the consumer surplus[br]changes as well.

0:02:31.590,0:02:33.710
In this case, it gets a lot smaller.

0:02:33.710,0:02:35.610
What about producer surplus?

0:02:35.610,0:02:40.840
Well, again, the price[br]which the sellers receive falls.

0:02:40.840,0:02:44.650
So producer surplus is no longer[br]this large blue area,

0:02:44.650,0:02:48.760
but is now just[br]this much smaller blue area.

0:02:48.760,0:02:54.140
So the tax reduces consumer surplus[br]and it reduces producer surplus.

0:02:54.140,0:02:56.060
Now, what about[br]this area in the middle?

0:02:56.060,0:02:58.090
Well, fortunately,[br]that's not wasted.

0:02:58.090,0:03:00.690
That, in fact, is tax revenues.

0:03:00.690,0:03:05.440
So notice that the tax -- [br]the height of the tax here -- is $1,

0:03:05.440,0:03:08.460
and there are 500 units exchanged,

0:03:08.460,0:03:13.138
so the government gets $1[br]for each of those 500 units.

0:03:13.138,0:03:16.376
So this revenue,[br]tax revenue, is the area.

0:03:16.376,0:03:20.356
It's the height[br]of this box times the width,

0:03:20.356,0:03:24.430
and the height is the tax,[br]the width is the quantity exchanged.

0:03:24.430,0:03:26.740
So this is tax revenue.

0:03:26.740,0:03:29.766
Now, what about[br]this final bit over here?

0:03:29.766,0:03:32.260
That used to be consumer[br]and producer surplus,

0:03:32.260,0:03:35.900
but now it's deadweight loss.

0:03:35.900,0:03:40.479
Nobody gets that.[br]That is lost gains from trade.

0:03:40.479,0:03:43.999
So remember,[br]people used to trade 700 units.

0:03:43.999,0:03:46.490
Now they're only trading 500 units.

0:03:46.490,0:03:49.740
Those units[br]were benefitting people,

0:03:49.740,0:03:51.370
but they're not anymore

0:03:51.370,0:03:54.110
because these trades[br]are not occurring.

0:03:54.110,0:03:56.350
I'm going to explain that[br]in a little bit more detail

0:03:56.350,0:03:58.210
in the next slide.

0:03:58.440,0:04:01.210
For now, just be sure[br]that you understand

0:04:01.210,0:04:03.580
how to label these areas.

0:04:03.580,0:04:06.160
So this is the new consumer surplus,

0:04:06.160,0:04:09.220
tax revenues,[br]the new producer surplus,

0:04:09.220,0:04:12.530
and this area is deadweight loss.

0:04:12.530,0:04:16.300
Okay, let's explain deadweight loss[br]in a little bit more detail.

0:04:16.300,0:04:18.969
Here's the way[br]to think about deadweight loss.

0:04:18.969,0:04:21.079
Suppose that you're planning[br]a trip to New York

0:04:21.079,0:04:22.770
and you're going to take the bus.

0:04:22.770,0:04:24.290
The benefit of the trip to you,

0:04:24.290,0:04:27.142
the value of seeing[br]the sights in New York is $50.

0:04:27.142,0:04:30.064
The cost of the bus ticket is $40.

0:04:30.064,0:04:32.807
So do you take the trip?[br]Is it a value?

0:04:32.807,0:04:34.160
Yes, you take the trip.

0:04:34.160,0:04:37.370
The total value of the trip is $10,[br]it's a positive,

0:04:37.370,0:04:39.280
so you decide to take the trip.

0:04:39.280,0:04:41.240
Trips is equal to one.[br]You make the trip.

0:04:41.240,0:04:42.770
Okay, no problem.

0:04:42.770,0:04:47.330
Now, suppose there's a tax[br]of $20 on bus fares

0:04:47.330,0:04:50.200
and let's suppose[br]that raises the cost of the trip

0:04:50.200,0:04:54.080
from $40 to $60.

0:04:54.080,0:04:56.390
It doesn't have to raise it[br]by exactly that amount,

0:04:56.390,0:04:58.820
by exactly the $20,[br]but let's suppose it does.

0:04:58.820,0:05:02.860
Okay, so the cost[br]of the trip is now $60.

0:05:02.860,0:05:04.660
The benefit is still $50.

0:05:04.660,0:05:07.450
So do you take the trip? No.

0:05:07.450,0:05:10.850
The benefit is less than the cost.

0:05:10.850,0:05:14.750
So now, no trip.[br]Trips are equal to zero.

0:05:14.750,0:05:17.930
Does the government[br]raise any revenue from you?

0:05:18.660,0:05:19.560
No.

0:05:19.560,0:05:23.920
Since you don't take the trip,[br]the government makes no revenue.

0:05:23.920,0:05:27.060
Is there a deadweight loss?[br]Yes.

0:05:27.440,0:05:30.360
You have lost[br]the value of the trip.

0:05:30.360,0:05:34.500
You used to, when there was no tax,[br]you took the trip, it was worth $10,

0:05:34.500,0:05:38.160
so the world was better off[br]by that $10 of value.

0:05:38.160,0:05:41.290
Now with the tax,[br]you don't take the trip,

0:05:41.290,0:05:44.230
so that $10 is a deadweight loss.

0:05:44.230,0:05:45.210
It's gone.

0:05:45.210,0:05:49.660
And notice that it's[br]not made up for by revenue.

0:05:49.660,0:05:51.340
There's no revenue.

0:05:51.340,0:05:58.050
So deadweight loss[br]is the value of the trips not made

0:05:58.050,0:05:59.650
because of the tax,

0:05:59.650,0:06:03.020
and there's no revenue[br]on trips which aren't made.

0:06:03.020,0:06:04.640
Government only makes revenue

0:06:04.640,0:06:06.940
on the trips[br]which continue to occur.

0:06:06.940,0:06:08.330
So deadweight loss

0:06:08.330,0:06:11.810
is the value of the trips[br]not made because of the tax.

0:06:12.420,0:06:15.540
Now, to return this[br]to a more general case,

0:06:15.540,0:06:18.540
instead of trips,[br]let's just replace that with trades.

0:06:18.940,0:06:20.730
Deadweight loss

0:06:20.730,0:06:25.420
is the value of the trades not made[br]because of the tax.

0:06:25.770,0:06:28.230
Very quickly,[br]here's our diagram again.

0:06:28.230,0:06:31.550
Before the tax,[br]there were 700 trades.

0:06:31.550,0:06:34.830
After the tax,[br]there were 500 trades.

0:06:34.830,0:06:39.510
So these are the 200 trades[br]which are not made

0:06:39.510,0:06:41.330
because of the tax.

0:06:41.330,0:06:44.710
And the value[br]of those 200 trades occurs

0:06:44.710,0:06:46.690
because for these trades,

0:06:46.690,0:06:49.390
the demanders value them

0:06:49.390,0:06:54.270
more than it costs the suppliers[br]to provide those trades.

0:06:54.270,0:06:58.190
So the demanders value the trades[br]as given by the demand curve,

0:06:58.190,0:06:59.980
the height of the demand curve.

0:06:59.980,0:07:03.080
The suppliers are willing[br]to supply those trades --

0:07:03.080,0:07:06.900
the cost to them is given[br]by the height of the supply curve.

0:07:06.900,0:07:12.880
So the value, the value[br]minus the costs, if you like,

0:07:12.880,0:07:15.160
is given by this triangle.

0:07:15.160,0:07:18.260
Because those trades[br]no longer occur,

0:07:18.260,0:07:22.630
that value is no longer produced --[br]that's deadweight loss,

0:07:22.630,0:07:26.470
the value of the trades[br]which don't occur because of the tax.

0:07:26.900,0:07:29.650
Here's one more important point[br]about deadweight loss.

0:07:29.650,0:07:32.240
Deadweight losses are larger

0:07:32.240,0:07:36.060
the more elastic the demand curve[br]holding revenues constant.

0:07:36.060,0:07:40.690
So for example, which of these[br]goods would we more like to tax --

0:07:40.690,0:07:44.770
the one on the left[br]where the demand curve is elastic

0:07:44.770,0:07:46.200
or the one on the right

0:07:46.200,0:07:49.130
where the demand curve[br]is more inelastic?

0:07:49.130,0:07:51.460
Notice that tax revenues[br]are the same.

0:07:51.460,0:07:54.710
So if we have a choice,[br]which good do we want to tax?

0:07:54.710,0:07:59.060
Well, pretty clearly, we want to tax[br]the good with the inelastic demand

0:07:59.060,0:08:02.960
because the deadweight losses,[br]the lost gains from trade,

0:08:02.960,0:08:06.800
are much smaller over here[br]than they are over here.

0:08:06.800,0:08:09.930
So the tax on the good[br]with the elastic demand --

0:08:09.930,0:08:13.210
it's creating a lot of waste[br]in order to get this revenue.

0:08:13.210,0:08:16.340
Over here, the tax on the good[br]with the inelastic demand --

0:08:16.340,0:08:20.750
there's only a little bit of waste[br]for the same amount of revenue.

0:08:20.750,0:08:23.230
The intuition here is pretty simple.

0:08:23.230,0:08:29.820
If the demand curve is inelastic,[br]then a tax won't deter many trades.

0:08:29.820,0:08:30.950
And that's what we don't want.

0:08:30.950,0:08:33.020
We don't want[br]to deter a lot of trades,

0:08:33.020,0:08:36.630
because it's the lost gains[br]from trade

0:08:36.630,0:08:39.250
which create the problem.

0:08:39.250,0:08:44.350
We don't get any tax revenue[br]when we deter a trade.

0:08:44.350,0:08:47.630
There's no tax revenue[br]when you deter an exchange.

0:08:47.630,0:08:49.060
So we want to make sure

0:08:49.060,0:08:51.970
that we deter[br]as few exchanges as possible

0:08:51.970,0:08:55.740
and that will maximize our revenue[br]compared to our loss.

0:08:56.270,0:08:59.420
Now, sometimes economists[br]are laughed at or derided

0:08:59.420,0:09:03.120
because this implies, for example,[br]that you ought to tax insulin,

0:09:03.120,0:09:08.590
a good with a very inelastic demand.

0:09:08.770,0:09:10.070
Now, there are many reasons

0:09:10.070,0:09:11.070
for taxing some goods[br]and not other goods,

0:09:11.070,0:09:13.070
depending upon[br]who uses the insulin,

0:09:13.070,0:09:16.850
whether it's poor people[br]or rich people

0:09:16.850,0:09:19.850
or how important[br]health is and so forth.

0:09:19.850,0:09:22.650
Nevertheless, as a general rule,

0:09:22.650,0:09:25.650
it is better to tax goods[br]with an inelastic demand

0:09:25.650,0:09:28.210
than goods with an elastic demand.

0:09:28.210,0:09:29.210
That's important,

0:09:29.210,0:09:31.210
and let me give you[br]an illustration of that.

0:09:31.210,0:09:32.210
Here's something

0:09:32.210,0:09:34.410
which you might think[br]would be a good idea to tax ---

0:09:34.410,0:09:35.460
luxury yachts.

0:09:35.460,0:09:36.460
They're only bought by the rich,

0:09:36.460,0:09:38.460
so you're not really[br]harming people very much, right?

0:09:38.460,0:09:41.620
Well, maybe so.

0:09:41.620,0:09:42.620
However, in 1990,

0:09:42.620,0:09:44.620
the federal government[br]actually applied a 10% luxury tax

0:09:44.620,0:09:49.860
to many luxury goods,[br]including pleasure boats or yachts

0:09:50.040,0:09:53.740
with a sales price above $100,000.

0:09:53.740,0:09:56.740
They expected tax revenue[br]of $31 million.

0:09:56.740,0:09:59.180
The reality, however,[br]was quite different.

0:09:59.180,0:10:02.180
The tax revenues[br]were only $16.6 million.

0:10:02.180,0:10:05.400
That was because sales of yachts[br]fell tremendously.

0:10:05.400,0:10:08.400
Perhaps the yacht buyers decided,

0:10:08.400,0:10:11.660
well, they could wait a year or two[br]before buying their yacht,

0:10:11.840,0:10:13.210
see what happens.

0:10:13.210,0:10:14.210
Or maybe they decided

0:10:14.210,0:10:16.210
they could buy their yachts[br]in other countries.

0:10:16.210,0:10:17.620
Yachts are pretty easy[br]to move around the world.

0:10:17.620,0:10:20.620
After all, that's what they're for.

0:10:20.620,0:10:24.650
The net result, in fact,

0:10:24.650,0:10:27.650
was a loss of 7,000 jobs[br]in the yacht industry.

0:10:27.650,0:10:29.500
Indeed, the federal government[br]ended up paying out more

0:10:29.500,0:10:32.500
in unemployment benefits[br]to unemployed yacht workers

0:10:32.500,0:10:39.790
than it collected[br]in tax revenues from yachts.

0:10:39.970,0:10:45.860
Because of this, the federal tax[br]was repealed in 1993.

0:10:46.040,0:10:47.270
The lesson here --

0:10:47.270,0:10:48.270
don't tax goods[br]which have really elastic demands.

0:10:48.270,0:10:50.270
You're not going to get[br]a lot of revenue,

0:10:50.270,0:10:51.620
you're going to deter[br]a lot of trades,

0:10:51.620,0:10:54.620
and that will create[br]a lot of deadweight loss,

0:10:54.620,0:10:56.410
and perhaps,[br]secondary losses for other people,

0:10:56.410,0:10:59.410
such as the workers.

0:10:59.410,0:11:01.610
That's it actually for taxes.

0:11:01.610,0:11:04.610
The only thing[br]we have left to do is subsidies.

0:11:04.610,0:11:06.370
We can actually do that[br]in the next lecture pretty quickly

0:11:06.370,0:11:09.370
because subsidies[br]are just negative taxes.

0:11:09.370,0:11:11.400
So everything[br]we've said about taxes,

0:11:11.400,0:11:14.400
with just a few changes[br]to our language,

0:11:14.400,0:11:15.400
will go through[br]with subsidies as well.

0:11:15.400,0:11:16.830
Thanks.

0:11:16.830,0:11:20.070
- [Narrator][br]If you want to test yourself,

0:11:20.070,0:11:23.070
click “Practice Questions.”

0:11:23.070,0:11:25.778
Or, if you're ready to move on,[br]just click “Next Video.”

0:11:26.304,0:11:28.400
♪ [music] ♪