Question

3. Governor Greg has decided to tax the sale of widgets. In the city of Destral the demand elasticity for widgets is −1.5 while in the city of Daxia the demand elasticity is −3.4. Prior to the tax, both cities demanded the same amount of textbooks. In which city will the tax generate more deadweight loss? Why? Illustrate your answer.

Answer 1

The size of the deadweight loss depends on tax rate and the reduction in quantity from pre tax quantity. Now when demand / supply is fairly elastic, reduction in quantity from pre tax quantity is very large while for inelastic demand / supply, reduction in quantity from pre tax quantity is small relatively. Hence, when demand or supply is relatively elastic deadweight loss is smaller

Here, the city of Destral has demand elasticity for widgets = −1.5 while the city of Daxia has demand elasticity = −3.4. This shows that Destral has relatively less elastic demand for widgets than Daxia. Due to this reason, Destral experience a greater deadweight loss of taxation while Daxia will have a smaller deadweight loss from tax.

Destral Daxia Price 22 01 YD2 \D2 D1 Q1 QO Quantity Q1 QO Quantity