Question

Show graphically and explain how an increase in taxes assessed on a good affects the welfare generated by that good’s market.

Answer 1

---- ------ to Qq Q,

Initial consumer surplus Area = Triangle EGH

Initial producer surplus Area = Triangle EFH

On imposing a tax on the good raise the price from P1 to P2 paid by consumer while reduces the price received by producers from P1 to P3  So, the equilibrium moves from E to E' which reduces quantity from Q1 to Q2.

After imposing tax:

Consumer surplus Area = Triangle CE'G

Consumer surplus Area = Triangle ABF

Deadweight loss Area = Triangle AEE'

Government earns as tax revenue = Area Rectangle ABCE'

So, the area of Deadweight loss (Triangle AEE') is the reduction in welfare generated by that good’s market.

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