What is the efficiency loss of a tax, and how does it relate to elasticity of demand and supply?

What Is Elastic?

Elastic is a term used in economics to describe a change in the behavior of buyers and sellers in response to a change in price for a good or service. In other words, demand elasticity or inelasticity for a product or good is determined by how much demand for the product changes as the price increases or decreases. An inelastic product is one that consumers continue to purchase even after a change in price. The elasticity of a good or service can vary according to the number of close substitutes available, its relative cost, and the amount of time that has elapsed since the price change occurred.

Key Takeaways

• Companies that operate in highly competitive industries offer products and services that are elastic, as the companies tend to be price-takers.
• When the price of a good or service has reached the point of elasticity, sellers and buyers quickly adjust their demand for that good or service.
• Elasticity is an important economic measure, particularly for sellers of goods or services, because the reflects how much of a good or service buyers will consume when the price increases or decreases.
• Products or services that are elastic are either unnecessary or can be easily replaced with a substitute.

What Is Elasticity?

Elastic Explained

Companies that operate in fiercely competitive industries provide goods or services that are elastic because these companies tend to be price-takers or those that must accept prevailing prices. When the price of a good or service reaches the point of elasticity, sellers and buyers quickly adjust their demand for that good or service. The opposite of elastic is inelastic. When a good or service is inelastic, sellers and buyers are not as likely to adjust their demand for a good or service when the price changes.

Elasticity is an important economic measure, particularly for the sellers of goods or services, because it indicates how much of a good or service buyers consume when the price changes. When a product is elastic, a change in price quickly results in a change in the quantity demanded. When a good is inelastic, there is little change in the quantity of demand even with the change of the good's price. The change that is observed for an elastic good is an increase in demand when the price decreases and a decrease in demand when the price increases.

Elasticity also communicates important information to consumers. If the market price of an elastic good decreases, firms are likely to reduce the number of goods or services they are willing to supply. If the market price goes up, firms are likely to increase the number of goods they are willing to sell. This is important for consumers who need a product and are concerned with potential scarcity.

Real-World Examples of Elastic Goods

Typically, goods that are elastic are either unnecessary goods or services or those for which competitors offer readily available substitute goods and services. The airline industry is elastic because it is a competitive industry. If one airline decides to increase the price of its fares, consumers can use another airline, and the airline that increased its fares will see a decrease in the demand for its services. Meanwhile, gasoline is an example of a relatively inelastic good because many consumers have no choice but to buy fuel for their vehicles, regardless of the market price.

What Is a Deadweight Loss Of Taxation?

The term deadweight loss of taxation refers to the measurement of loss caused by the imposition of a new tax. This results from a new tax that is more than what is normally paid to the government's taxing authority. This theory suggests that imposing a new tax or raising an old one can backfire, resulting in insufficient or no gains in government revenues due to the decline in demand for the goods or services being taxed. A deadweight loss, therefore, disrupts the balance between supply and demand. English economist Alfred Marshall is widely credited as the originator of deadweight loss analysis.

Key Takeaways

• Deadweight loss of taxation measures the overall economic loss caused by a new tax on a product or service.
• It analyses the decrease in production and the decline in demand caused by the imposition of a tax.
• It is a lost opportunity cost.

Understanding Deadweight Loss of Taxation

Governments impose taxes to collect revenues. These funds are used to support public programs and projects, such as infrastructure, economic aid, and social services. Federal, state, and local governments frequently decide to raise taxes in order to raise revenues to cover shortfalls. Although this action may seem like a good idea, it often has the opposite effect. This is called a deadweight loss of taxation or, simply, a deadweight loss.

Here's how it works. When the government raises taxes on certain goods and services, it collects that tax as additional revenue. Taxes, though, result in a higher cost of production and a higher purchase price for the consumer. This, in turn, causes production volumes (and, therefore, supply) to drop, leading to a drop in demand for these goods and services. This gap between the taxed and tax-free production volumes is the deadweight loss. 

This theory was developed by Alfred Marshall, an economist who specialized in microeconomics. According to Marshall, supply and demand are directly related to production and cost. These points intersect in the middle. So, when one changes, it throws off the balance.

Although there isn't a consensus among experts about whether deadweight loss can be accurately measured, many economists agree that taxation can often be counter-productive. This makes a deadweight loss of taxation a lost opportunity cost.

Deadweight loss of taxation may be viewed as the overall reduction in demand and the subsequent decline in production levels that follow the imposition of a tax, which is usually represented graphically.

Special Considerations

Taxation reduces the returns from investments, wages, rents, and entrepreneurship. This, in turn, reduces the incentive to invest, work, deploy property, and take risks. But it also encourages taxpayers to spend time and money trying to avoid their tax burden, diverting valuable resources from other productive uses.

Most governments levy taxes disproportionately on different people, goods, services, and activities. This distorts the natural market distribution of resources. The limited resources will move from their otherwise optimal use, away from heavily taxed activities and into lightly taxed activities, which may not be advantageous to all.

Deadweight Loss of Deficit Spending and Inflation

The economics of taxation also apply to other forms of government financing. If a government finances activities through bonds rather than taxation, deadweight loss is only delayed. Higher future taxes must be levied to pay off the bond debt.

The deadweight loss of inflation is nuanced. Inflation reduces the economy’s production volume in three ways:

• Individuals divert resources towards counter-inflationary activities.
• Governments engage in more spending and deficit financing becomes a hidden tax.
• Expectations of future inflation reduce present private expenditures.

Deficit spending means borrowing, which only delays deadweight loss of taxation to some future date when the debt must be repaid.

Example of Deadweight Loss of Taxation

Here's a hypothetical example to show how the deadweight loss of taxation works. Let's say the mythical city-state of Braavos imposes a flat 40% income tax on all of its citizens. The government stands to collect an additional $1.2 trillion a year through this new tax.

That big chunk of money, which is now going to the government of Braavos, is no longer available for spending on consumer goods and services, or for consumer savings and investment.

Suppose consumer spending and investments decline at least $1.2 trillion, and total economic output declines by $2 trillion. In this case, the deadweight loss is $800 billion—the $2 trillion total output less $1.2 trillion consumer spending or investing equals a deadweight loss of $800 billion.

How is the deadweight loss of a tax related to the elasticity of the demand and supply curves?

What is efficiency loss?

What is the relationship between a tax and elasticity?

How does elasticity affect the deadweight loss of a tax?