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7.2 The Welfare Effects of Taxes, Subsidies, and Price Controls2
We can use consumer and producer surplus to measure the welfare effects of various government programs, such as taxes and price controls.
Welfare effects refer to the gains and losses associated with government intervention.
Exhibit 1: Supply and Demand of a Tax
After a tax is imposed, consumers pay a higher price and lose the corresponding amount of consumer surplus as a result. Producers receive a lower price after tax and lose the corresponding amount of producer surplus as a result. The government gains the amount of the tax revenue generated, which is transferred to others in society.
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The net loss to society, or deadweight loss, of a tax is the difference between the lost consumer and producer surplus and the tax revenue generated, represented graphically as the deadweight loss triangle.
The deadweight loss of a tax occurs because the tax reduces the quantity exchanged below the original output level, reducing the size of the total surplus realized from trade. The tax distorts market incentives--the price to buyers is higher than before the tax, so they consume less, and the price to sellers is lower than before the tax, so they produce less. This leads to deadweight loss, the lost gain from mutually beneficial trades.
Exhibit 2: Welfare Effects of a Tax
The size of the deadweight loss from a tax, as well as how the burdens are shared between buyers and sellers, depends on the elasticities of supply and demand. Other things equal, the less elastic the demand curve, the smaller the deadweight loss. Similarly, the less elastic the supply curve, the smaller the deadweight loss. However, if either the supply or demand curves become more elastic, the deadweight loss will be larger, because a given tax will reduce the quantity exchanged by a greater amount. That is, the more elastic the curves are, the greater the change in output and the larger the deadweight loss.
Exhibit 3: Elasticity and Deadweight Loss
Elasticity differences can help us understand tax policy. Those goods that are heavily taxed often have a relatively inelastic demand curve in the short run. This means that the burden falls mainly on the buyer. It also means that the deadweight loss to society is smaller than if the demand curve was more elastic.
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A subsidy lowers the price to buyers, increasing the quantity exchanged and consumer surplus. Producer surplus also increases. However, the cost to the government (taxpayers) is greater than the gains to consumers and producers, causing a deadweight cost or welfare loss to society.
Exhibit 4: Welfare Effects of a Subsidy
We can see the welfare effects of a price ceiling by observing the change in consumer and producer surplus from the implementation of the price ceiling. Consumers can now buy at a lower price, but cannot buy as much as before (since suppliers will not supply as much). Producers lose producer surplus from the lower imposed ceiling price. The net loss is the resulting deadweight loss triangle, just as with a tax.
Exhibit 5: Welfare Effects of a Price Ceiling
Rent control is used as an example of the welfare effects of a price ceiling, extended to show the difference between the short run and the long run, in terms of the effects on quantity exchanged and the welfare cost.
Exhibit 6: Deadweight Loss of Rent Control—Short Run vs. Long Run
We can also use consumer and producer surplus to see the welfare effects of a price floor, where the government buys up the surplus. Consumers lose consumer surplus due to the higher price floor, and must also pay taxes to pay for the buying and storing of the unsold (to consumers) output. Producers gain producer surplus from the higher prices and greater output (since the government buys up what is not sold on the market). On net, there is a deadweight loss from the price floor, illustrated in Exhibit 7.
Exhibit 7: Welfare Effects of a Price Floor When Government Buys the Surplus
Use What You’ve Learned: Quantifying Consumer and Producer Surplus
A deficiency payment program, with a smaller welfare cost than agricultural price supports, is also illustrated with the same consumer and producer surplus tools.
Exhibit 8: Welfare Effects of a Deficiency Payment Plan
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