Question

Under what conditions are the deadweight losses from a tax:

         Relatively small:

         Relatively large:

Answer 1

Before we understand Deadweight Losses from Tax we have to understand Deadweight Losses:-

It is the loss of economic efficiency in terms of utility for consumers/producers such that the optimal or allocative efficiency is not achieved.

Deadweight loss can be stated as the loss of total welfare or the social surplus due to reasons like taxes or subsidies, price ceilings or floors, externalities and monopoly pricing. It is the excess burden created due to loss of benefit to the participants in trade which are individuals as consumers, producers or the government.As if a certain tax is imposed on the producer for each unit of the good he sells, it is likely that the new equilibrium price that is settled for the transaction will be higher and therefore some burden of this will be passed on to the consumer.

This will lead to reduced trade from both sides. The loss of welfare attributed to the shift from earlier to this less efficient market mechanism is called the deadweight loss of taxation. This leads to wastage or underutilization of resources due to inefficient market outcomes..

Relatively small when The amount of the deadweight loss varies with both demand elasticity and supply elasticity. When either demand or supply is inelastic, then the deadweight loss of taxation is smaller, because the quantity bought or sold varies less with price.

. Relatively large when Price elasticities of supply and demand, which measure how much the quantity supplied and quantity demanded respond to changes in the price. The deadweight loss is the reduction in total surplus due to the tax. ... 3) As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger.