Surplus & Taxation

Dr. Tutan Ahmed

IIT Kharagpur
 Consumer Surplus

●consumer surplus Difference

between what a consumer is willing
to pay for a good and the amount
actually paid.

Consumer surplus is the total benefit

from the consumption of a product,
less the total cost of purchasing it.

Here, the consumer surplus associated

with six concert tickets (purchased at
$14 per ticket) is given by the yellow-
shaded area.
 Consumer Surplus

For the market as a whole, consumer surplus is measured

by the area under the demand curve and above the line
representing the purchase price of the good.

Here, the consumer surplus is given by the yellow-shaded

triangle and is equal to 1/2 × ($20 − $14) × 6500 =
$19,500.

When added over many individuals, it measures the

aggregate benefit that consumers obtain from buying
goods in a market.

When we combine consumer surplus with the aggregate

profits that producers obtain, we can evaluate both the
costs and benefits not only of alternative market structures,
but of public policies that alter the behavior of consumers
and firms in those markets.
Producer’s Surplus
 Welfare Maximization

●Consumer surplus = Value to buyers – Amount paid by buyers

●Producer surplus = Amount received by sellers – Cost to sellers
●Total Surplus = Consumer surplus + Producer surplus
●Total surplus = Value to buyers – Cost to sellers

If an allocation of resources maximizes total surplus, we say that the allocation exhibits
efficiency or welfare is maximized
 Welfare Maximization

●Why Trade Happens

●Importance of Market Economy
 Taxation

“Taxes are what we pay for civilized society.” - Oliver

Wendell Holmes
 Taxation

• Government collects revenue - through taxation

• How does a tax affect consumer surplus, producer surplus, and total surplus?
• What is the deadweight loss of a tax?
• What factors determine the size of this deadweight loss?
• How does tax revenue depend on the size of the tax?

Why is taxation needed?

 Taxation

• A tax is a wedge between the price buyers pay and the price sellers
receive.
• A tax raises the price buyers pay and lowers the price sellers receive.
• A tax reduces the quantity bought & sold.
• These effects are the same whether the tax is imposed on buyers or sellers,
so we do not make this distinction in this chapter.
 The Effects of a Tax
P
With no tax,
price is PE and
quantity is QE . Size of tax = $T
S
Govt imposes a tax PB
of $T per unit. PE
The price buyers
pay is PB , PS D

the price sellers

receive is PS ,
Q
and quantity is QT . QT QE
 The Effects of a Tax
P
The tax generates
revenue equal to
Size of tax = $T
$T x QT .
S
PB

PE

PS D

Q
QT QE
 The Effects of a Tax
Without a tax, P

CS = A + B + C
PS = D + E + F A
Tax revenue = 0 S
B C
Total surplus PE
= CS + PS D E
=A+B+C D
+D+E+F F

Q
QT QE
 The Effects of a Tax
P
With the tax,
CS = A
PS = F
A
Tax revenue S
PB
=B+D B C
Total surplus D E
=A+B PS D
+D+F F
The tax causes total
surplus to fall by
Q
C+E QT QE
 The Effects of a Tax
P
C + E is called the
deadweight loss (DWL)
of the tax, the fall in total A
surplus that S
PB
results from a market B C
distortion, such as a tax.
D E
PS D
F

Q
QT QE
 About the Deadweight Loss
Because of the tax, the P
units between
QT and QE are not sold.
The value of these units S
to buyers is greater than PB
the cost of producing
them,
so the tax has prevented PS D
some mutually beneficial
trades.

Q
QT QE
 What Determines the Size of the DWL?
• The govt needs tax revenue to finance roads, schools, police, etc., so it
must tax some goods and services.
• Which ones? One answer is that govt should tax the goods or services
with the smallest DWL.
• So when is the DWL small vs. large? Turns out it depends on the
elasticities of supply and demand.
• Recall: The price elasticity of demand (or supply) measures how much
quantity demanded
(or supplied) changes when the price changes.
 DWL and the Elasticity of Supply

When supply
is inelastic, P
the DWL of a tax is S
small.

Size
of tax

D
Q
 DWL and the Elasticity of Supply

The more elastic is S

supply, Size
of tax
the larger is
the DWL.

D
Q
 DWL and the Elasticity of Demand

When demand
P
is inelastic,
the DWL of a tax S
is small.
Size
of tax

D
Q
 DWL and the Elasticity of Demand

The more elastic is

demand, Size
the larger is of tax
D
the DWL.

Q
 Why Elasticity Affects the Size of DWL
• A tax distorts the market outcome: consumers buy less and
producers sell less, so new equilibrium is below the surplus-
maximizing quantity.
• Elasticity measures how much buyers and sellers respond to
changes in price, and therefore determines how much the
tax distorts the market outcome.
 DWL and the Size of the Tax
P
Initially, the tax is T per new
unit. DWL
Doubling the tax
causes the DWL to more S
than double.
2T T
When a tax increases,
DWL rises even more. D
initial
Assignment: Your role as
DWL
the Economic Adviser to
the Finance Minister Q
Office. Look at the previous Q2 Q1
taxation rate on various
items. Prescribe next year
taxes (item wise)
Taxation Burden Sharing between Buyer and Seller

• Buyer’s share of tax burden= Elasticity of Supply/(|Elasticity of

Demand| + Elasticity of Supply)

• Seller’s share of tax burden= |Elasticity of Demand|/(|Elasticity of

Demand| + Elasticity of Supply)

• Tax burden is dependent on Relative Elasticity

 Taxation Burden Sharing between Buyer and Seller

Intuition behind the importance of the use of relative elasticity: let’s

say elasticity of supply is high but elasticity of demand is low. If the tax
is high, supplier supplies less. But buyer has to buy almost the same
quality. Therefore, the effect of taxation is directly on the buyer as well
as indirectly on the buyer through the effect on supplier.

Scenarios:

PE of Supply – elastic, PE of Demand – inelastic

Three other cases

 Taxation Burden Sharing between Buyer and Seller

Solve the following problem:

Initial Price: $10, Quantity Demanded and Supplied = 100 A Tax of $2

is imposed. Elasticity of demand = -.5 and Elasticity of Supply = 1.5.
What is the tax burden for buyer and seller? How much the buyer
would pay? How much the seller would receive?
 Revenue and the Size of the Tax

The Laffer curve

shows the relationship Tax
The Laffer curve
between revenue
the size of the tax and
tax revenue.

Tax size
 Taxation in a nutshell
• A tax on a good reduces the welfare of buyers and sellers. This welfare loss
usually exceeds the revenue the tax raises for the govt.
• The fall in total surplus (consumer surplus, producer surplus, and tax revenue)
is called the deadweight loss (DWL) of the tax.
• A tax has a DWL because it causes consumers to buy less and producers to
sell less, thus shrinking the market below the level that maximizes total
surplus.
• Types of taxation
 Income tax rate and Labor Supply

Mankiw: pp170

Why Scandinavian countries maintain such a high tax rate even when taxation
doesn’t appear to be a great idea? More importantly, how these countries are
managing the top positions in different human development indices?
 Different Types of Taxation and Challenges

What are the different challenges of purely income tax regime:

a) elasticity of labor supply b) incentive to work and save c)
progressive nature of taxation and its impact d) administrative
complexity e) taxation on the consumption as well as on the
savings and its impact
What are the different challenges of purely consumption tax
regime: a) inequality inducing and regressive nature of taxation
b) high elasticity of consumption may lead to high DWL c)
enforcement complexity
Assignment: Can we see if Laffer curve is applicable in India?
 Some follow-up questions?
• Should Government impose an income tax or a consumption tax?
• Clue: Income = Consumption + Savings, taxation on income includes taxation
on savings
• Clue: [Link]
• Should we tax luxury items? The case of taxation on expensive boats in the
United States in 1990
• Assignment: What is the present taxation system in India? Should India
have a pure income tax or a pure consumption tax regime? According to
you, what other changes may be brought to maximize the welfare of
India?

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