Question

1. Explain what happens to the efficiency of free markets if:

a) There is market power exercised by buyers or sellers.

b) There are externalities

2. What is the relationship between a change in the size of a tax, and the change in the deadweight loss of the tax?

3. What is the best predictor of whether reducing a tax in a market will increase or decrease tax revenue? Explain.

Answer 1

1. a) If there is a market power exercised by the buyers or sellers the overall efficiency of the free market is reduced or lost. This is because if there is a market power with buyers the price of the good or service is less and hence there may be a loss to the seller or in the other case if there is a market power with the seller the price of goods and services is high and hence there is a loss to the buyers.

b) The presence of externalities (both positive and negative) also decreases the overall efficiency of the free market. This is because a negative externality is harmful as it incurs cost to third party for which he is not paid and though a positive externality is profitable for the third party but it is a loss to the person doing production or consumption. So in both the cases there is overall loss of efficiency in the economy.

2. There is a positive relationship between the change in the size of a tax and change in the dead weight loss of the tax, this is because it is generally seen that with increase in the size of a tax i.e if the tax rate increases the dead weight loss resulting from the tax also increases. This happens because with an increase in the size of tax, the price of the goods and services increases or the disposable income if people decreases and hence they can only buy fewer goods than before.

3. whether reducing a tax in a market will increase or decrease tax revenue depends on the MPC (marginal propensity to consume) and MPS (marginal propensity to save) because if MPC is high, than a decrease in tax will increase disposable income and hence increases consumption and hence increases demand and production which leads to more economic activities and more income and hence more tax revenue. For indirect taxes it depends on the price elasticity of demand.