Deadweight Loss and Taxation
- mansigoyal | Sat Mar 13 2021
Economics dwell around the fact, “Resources are scarce with limitless wants”. Economic efficiency is the situation in which every scarce resource is utilised in a manner to maximise the benefits to both the consumers and producers. Pareto efficiency is a point in the economy when no party can be better off without making someone else worse off. Hence, pareto economic point is the point of economic efficiency. Does our economy always achieve the state of economic efficiency? Certainly not. This lacuna is termed as deadweight loss. Deadweight loss refers to loss of economic efficiency when the equilibrium output is not achieved in the economy. Basically, to start with there are four main causes of deadweight loss. First, Price floor is the setting of a lower limit that can be charged for a good and service which is above the equilibrium price in the economy. For example, Minimum Wage Act which provides for the minimum wages to a person. Second, Price ceiling is the setting of the upper limit of a price to be charged for a good or a service which is below the equilibrium price in the economy. For example, Rent Control provides the maximum rent to be charged from the tenants. Next, imperfect competition restricts the supply to increase the prices above the average total cost as in monopoly or oligopoly. Last, the government charges a tax on the selling price of a good or a service which also leads to deadweight loss. For example, Sin taxes on imposed on harmful products such as alcohol to dissuade the consumers from buying it. Let us have a deeper insight into deadweight loss of taxation. The intersection of demand and supply in the economy is termed as equilibrium point. Consider you and your friends are planning a trip to Goa. The price of the ticket is $60 per person and the benefit derived by is $80. Therefore, you will be ready to go for the trip due to the benefit derived by you outweighs the cost of the ticket by $20. Government imposes a tax of $45 on the selling price. Then the demand for the ticket is expected to fall. The fall in demand leads to the leftward shift of the demand curve. Now, the cost becomes $105 and the benefit you placed is $80 which is lower than the cost. You say a no to your friends due to the tax imposed by the government. This leads to a loss of revenue for the government and causes deadweight loss in the economy. Therefore, the government losses its revenue by imposing a tax on the selling price and this concept is denominated as deadweight loss of taxation.