Download Concepts of Welfare Economics

Excess Burden and
Deadweight Loss
Anderson: Efficiency Effects of Taxes and Subsidies
Introduction
• Taxes and subsidies can cause inefficiencies or
correct for inefficiencies in the market.
• In this chapter we learn how to analyze taxes and
subsidies for their efficiency effects.
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Excess Burden of Taxes and Subsidies
• Whenever a tax is placed on a good, service, or form of
income, people in the economy are burdened.
• Not only do they have to pay the tax, which is the first
form of burden, but they also are induced to change
their behavior as a result of the tax.
• That change of behavior causes a second form of
burden that we call the excess burden of the tax.
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Excess Burden
• The excess burden of a tax refers to the welfare loss caused by
imposition of the tax, over and above the revenue the tax generates.
• In this chapter we consider the causes of excess burden and consider
ways to minimize the size of excess burdens resulting from taxation.
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Excess Burden With Demand Curves
• The simplest way to show excess burden is with a
demand curve,
• Although a special type of demand curve is needed
called a compensated demand curve.
• This type of demand curve takes out the income
effects of price changes and only shows the
substitution effects.
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Figure 10.1: Ordinary and Compensated Demand
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Figure 10.2: Excess Burden of a Tax
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Excess Burden Formula
EBx  (1 / 2)x xpxt x
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Figure 10.3: Excess Burden When Tax Is Doubled
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Marginal Excess Burden
• It is important to consider how the excess burden of
a tax changes when there is a change in the tax rate.
• This concept is known as the marginal excess
burden (MEB) of a tax.
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Figure 10.4: Marginal Excess Burden of a Tax Increase
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Excess Burden of a Subsidy
• Subsidies also create excess burden.
• The excess burden is the cost of the subsidy in
excess of the welfare improvement created by the
subsidy.
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Figure 10.5: Excess Burden of a Subsidy
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Adding the Supply Side to the Story
• So far, we have assumed that the supply curve is
perfectly elastic (horizontal).
• If we assume that the supply curve is upward
sloping, we can generalize the formula for excess
burden.
• Assuming that the elasticity of supply is denoted x
we can write the generalized excess burden formula
as follows:
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Figure 10.6: Excess Burden With Upward Sloping Supply
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Generalized Excess Burden Formula
EBx  (1 / 2) xpx t x / (1 /  x  1 /  x )
2
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Generalized Excess Burden Formula
[continued]
• Notice that as the elasticity of supply becomes infinite,
the generalized formula collapses to the simple
formula first presented.
• Also notice that excess burden is directly related to
both elasticities.
• The larger the elasticity of demand or supply, the
larger the excess burden.
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The Special Cases of Inelastic
Demand and Supply
• The generalized excess burden formula also
indicates that the smaller the elasticity of demand
or supply, the smaller the excess burden of a tax.
• Consider the cases of zero elasticities of demand
and supply in Figure 7.
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Figure 10.7: Excess Burden When Demand or Supply is Inelastic
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Determinants of Excess Burden
• From the formula for excess burden, we know its
determinants include:
• Elasticities of demand and supply.
• Price of the good (which determines quantity).
• Tax rate applied to the good.
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