Chapter 7: Problem 9

The state needs to raise money, and the governor has a choice of imposing an excise tax of the same amount on one of two previously untaxed goods: the state can tax sales of either restaurant meals or gasoline. Both the demand for and the supply of restaurant meals are more elastic than the demand for and the supply of gasoline. If the governor wants to minimize the deadweight loss caused by the tax, which good should be taxed? For each good, draw a diagram that illustrates the deadweight loss from taxation.

Short Answer

Expert verified

Answer: To minimize the deadweight loss caused by the tax, the governor should tax gasoline rather than restaurant meals.

Step by step solution

Understand elasticity and deadweight loss

First, we need to understand that when demand and supply are more elastic, the burden of the tax is more sensitive to changes in price due to the tax. This will affect the deadweight loss, which is the difference between the consumer and producer surplus before and after taxation.

Draw the pre-taxation equilibrium for each good

For each good, draw the demand and supply curves on a graph with price on the vertical axis and quantity on the horizontal axis. Label the pre-taxation equilibrium points, prices, and quantities for both gasoline and restaurant meals.

Add the tax for each good

Now, add the excise tax to the supply curve for both goods. This will lead to a vertical shift of the supply curve upward by the amount of the tax. Label this new supply curve as S_new for both restaurant meals and gasoline.

Find the new equilibrium

With the new supply curves for both goods, determine the new equilibrium points (price and quantity) after the imposition of the tax. Label these points on the graphs.

Determine the deadweight loss for each good

To find the deadweight loss, look for the difference between the two triangle-shaped areas that used to be part of consumer and producer surplus before the tax and now are not part of any surplus (neither consumer nor producer). For each good, shade the deadweight loss area on the graph.

Compare the deadweight losses between two goods

Choose the good that has a smaller deadweight loss area on the graph. This will be the good that the governor should tax to minimize the deadweight loss caused by the tax. As the demand and supply of restaurant meals are more elastic than gasoline, it can be inferred that taxing gasoline will result in a smaller deadweight loss when compared to restaurant meals. To minimize the deadweight loss caused by the tax, the governor should tax gasoline rather than restaurant meals.