Question

2. What happens to the amount of deadweight loss as a tax increases? Explain and use mels supply/demand diagrams to defend your answer. udDly is

Answer 1

2) Deadweight loss is found as the area with the formula = 0.5 x size of the tax x reduction in quantity.

As the tax rate rises, quantity consumed is reduced and so the deadweight loss rises.

The greater the tax rate is, the greater will be the deadweight loss.

This is shown below. Initially there is no tax so there is no deadweight loss at E

When tax rate of AB is imposed, deadweight loss arises that is equivalent to the area ABE

When the tax rate is increased to CD, deadweight loss increases to area CDE.

AS the tax rate rises, the deadweight loss increases

Pricq () Supply SS T Demand DD Quantity (units)

3) Economist would go for more efficient provision which is the tradeable permits. This is because different firms have different ability to reduce pollution, some firms are more efficient in reducing pollution while others have high abatement costs. An equal reduction regulation will be inefficient since both efficient and inefficient firms have to reduce pollution by same amount. In case of permits, however, firms with lower abatement cost will sell their permits to firms with high abatement cost resulting in more efficient allocation.