Question

Suppose that policymakers are considering placing a tax on either of two markets. In Market A, the tax will have a significant effect on the price consumers pay, but it will not affect equilibrium quantity very much. In Market B, the same tax will have only a small effect on the price consumers pay, but it will have a large effect on the equilibrium quantity. Other factors are held constant. In which market will the tax have a larger deadweight loss?

Answer 1

The correct answer is Market B.

Step-by-step explanation:

To understand why taxes cause deadweight losses, remember one of the Ten Principles of the Economy of Other Articles: People Respond to Incentives. In another article we saw that free markets normally distribute scarce resources efficiently. That is, the balance between supply and demand maximizes the total surplus of buyers and sellers in a market. However, when a tax increases the price to buyers and reduces the price to sellers, it provides the former with an incentive to consume less and the latter an incentive to produce less than they would in the absence of the tax. Because both buyers and sellers respond to these incentives, the market size is reduced below its optimum. The distortion that taxes produce in incentives causes the market to distribute resources inefficiently.