Question

(1) Briefly explain why deadweight loss exist when a tax is imposed. Why would deadweight loss be lower if the tax is imposed on a good with inelastic demand? [3 Points)

Answer 1

Deadweight loss exists when a tax is imposed because it causes buyers and sellers to change their preferences. When a tax imposed raises the price of commodities, buyers will tend to buy less and when the tax lowers the price that can be realised by sellers, they reduce production.The purpose of the taxation is to raise revenue for the government, however, the value realised by the government is less than the loss in value realised by the market participants. In short, there's a loss of consumer surplus for buyers and loss of producer surplus for sellers.

Consumer Surplus Deadweight Loss Supply Prax ----- Tax Revenue Demand Producer Surplus

The triangle labelled deadweight loss in the graph represents the value of the transactions not made due to the imposition of the tax.

Deadweight loss would be lower if the tax was imposed on a good with inelastic demand as regardless of the change in price of the commodity, buyers would still consume as much of it as before (inelastic demand implies that demand isn't responsive to the change in price). Hence, there would't be as much of a loss in the value of transactions and tax revenues would be realised as well.