ECON1101 Chap.13 Taxes, Deadweight Loss and Tax Incidence
Taxes, Deadweight Loss and Tax Incidence
Taxes, Deadweight Loss and Tax Incidence models an excise tax as a wedge between the price buyers pay and the price sellers keep. It distinguishes per-unit from ad valorem taxes, shows that the statutory incidence does not change the outcome, and computes the welfare effects: lower consumer and producer surplus, tax revenue equal to the tax times the taxed quantity, and a deadweight loss.
It then explains why taxes cost least in inelastic markets and why the less price-sensitive side bears more of the burden. The drills compute incidence shares on a linear market and test the claim that halving a tax halves its social cost.
What this chapter covers
- 01
Per-unit and ad valorem taxes
- 02
The tax wedge between buyer and seller prices
- 03
Statutory incidence versus tax incidence
- 04
Welfare analysis of an excise tax
- 05
Deadweight loss and price sensitivity
- 06
Who bears the burden of a tax
Worked example · free
Welfare effects of a $6 per-unit tax
- 2Untaxed: 48 − q = 12 + 0.5q gives q = 24 at $24. The wedge requires (48 − q) − (12 + 0.5q) = 6, so 1.5q = 30 and q = 20.
- 1Buyers pay 48 − 20 = $28 and sellers receive 12 + 10 = $22.
- 1Revenue = 6 × 20 = $120.
- 1Deadweight loss = ½ × 6 × (24 − 20) = $12.
Key terms
- Excise tax
- An excise tax is a tax levied on a particular good or service.
- Ad valorem tax
- An ad valorem tax is a tax set as a percentage of the price, such as GST.
- Tax incidence
- Tax incidence is the division of a tax’s burden between buyers and sellers.
- Statutory incidence
- Statutory incidence is the legal obligation to pay a tax to the government, which need not match who bears it.
- Tax wedge
- The tax wedge is the gap between the price buyers pay and the price sellers receive, equal to a per-unit tax.
Taxes, Deadweight Loss and Tax Incidence FAQ
Does it matter whether a tax is collected from buyers or sellers?
Not for the outcome. Whichever side hands the money over, the market settles at the quantity where the gap between buyer and seller prices equals the tax, so prices, quantity and the split of the burden are the same.
Why does a tax create a deadweight loss?
The tax raises the buyer price and lowers the seller price, so fewer units are traded than at the efficient quantity. The units no longer traded were worth more to buyers than they cost to produce, and that lost surplus goes to no one.
Which markets should be taxed to keep the deadweight loss small?
Markets where buyers and sellers respond little to price. Quantity then falls only slightly, so the deadweight loss triangle is small and the tax base, and therefore the revenue, holds up.
Who bears more of a tax?
The side that is less price-sensitive. If demand is steeper than supply, buyers’ price rises by most of the tax; if supply is steeper, sellers’ price falls by most of it. The legal payer does not decide this.
How do I calculate each side’s share of a tax?
Compare the taxed prices with the untaxed equilibrium price. The rise in the price buyers pay is the buyers’ share and the fall in the price sellers receive is the sellers’ share; the two shares add up to the tax. Dividing each by the tax gives the proportions.
Is an ad valorem tax analysed differently from a per-unit tax?
The course models taxes as per-unit, a fixed gap between the buyer and seller prices. An ad valorem tax sets the gap as a percentage of the price, so the gap widens as the price rises, but the same logic applies: quantity falls, a wedge opens and a deadweight loss appears.
Exam move
Solve one tax problem from scratch every revision day: untaxed equilibrium, taxed quantity from the wedge, both prices, each side’s share, revenue and deadweight loss, then check that the losses add up. Draw the welfare diagram with all four regions labelled.
Close with two quick comparisons, an elastic against an inelastic market and a tax against half that tax, to fix the incidence rule and the squared effect on deadweight loss. For statement questions, prepare two sentences you can adapt: one explaining why the legal payer does not determine the burden, and one explaining why inelastic markets lose less surplus to a tax.
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