Question

Since both taxes and subsidies create a deadweight loss to society, why are they used to correct negative and positive externalities? Ensure to explain whether society is better off or worse off and why.

Answer 1

A deadweight loss is a cost to society created by market inefficiency, which occurs when supply and demand are out of equilibrium. Mainly used in economics, deadweight loss can be applied to any deficiency caused by an inefficient allocation of resources.

.In general, a tax raises the price the buyers pay, lowers the price the sellers receive, and reduces the quantity sold. If a tax is placed on a good and it reduces the quantity sold, there must be a deadweight loss from the tax. A tax will generate a greater deadweight loss if supply and demand are inelastic

The deadweight loss due to a subsidy is a form of economic inefficiency. It's a reduction in consumer and producer surplus, and is a result of the fact that the subsidy causes more than the socially best amount of the good is produced. And what is produced is sold at too low a price.

A deadweight loss also exists when there is a positive externality because at the market quantity, the marginal social benefit is greater than the marginal social cost. When an externality exists, the socially optimal output is not achieved.

If a good has a negative externality, then the cost to society is greater than the cost consumer is paying for it. Since marginal benefit is not equal to marginal cost, a deadweight welfare loss results. This graph shows the effect of a negative externality.

Deadweight loss occurs when supply and demand are not in equilibrium, which leads to market inefficiency. While certain members of society may benefit from the imbalance, others will be negatively impacted by a shift from equilibrium.