A tax regenerates revenue for government, but also reduces the gains from trade

In a free market, trade occurs whenever the buyer’s willingness to pay exceeds the suppliers willingness to sell (whenever demand curve lies above supply curve)

• Free market maximizes gains from trade, sum of consumer and producer surplus

Some of consumer and producer surplus are transferred to government in form of tax revenues, but consumer and producer surplus together decrease by more than government revenue increases (difference is “deadweight loss”)

• Deadweight loss: reduction in total surplus caused by a market distortion or inefficiency

A key factor determining deadweight loss is the elasticity of supply and demand

• deadweight loss from taxation is larger the more elastic the demand curve

  • Deadweight loss is the lost gains from trade

  • If demand curve is relatively elastic, then tax deters a lot of trades

  • If demand curve is relatively inelastic, then tax doesn’t deter many trades

Broad-based taxes will tend to create less deadweight loss than more narrowly based taxes

• Ex: an equal-revenue tax on fruit would generate less deadweight loss than on one fruit