Question

Suppose the government wants to levy a new excise tax. For each of the following goods, determine whether you would expect an excise tax to result in high or low deadweight loss. [LO 20.2] a. Alcohol. b. Milk. c. Diamonds. d. Tropical vacations. e. Socks.

Short answer

Excise tax would likely cause low deadweight loss for alcohol, milk, and socks, but high deadweight loss for diamonds and tropical vacations.

Step-by-step solution

Understanding Deadweight Loss

Deadweight loss is the reduction in economic efficiency that occurs when the equilibrium for a good or service is not achieved or when the market is not in perfect competition. The size of the deadweight loss depends on the elasticity of demand and supply. A good is likely to have higher deadweight loss if either the demand or supply, or both, are elastic.

Analyzing Alcohol

Alcohol is generally considered to have inelastic demand because people continue to purchase it regardless of price changes due to it being an addictive product. Hence, an excise tax on alcohol would result in a low deadweight loss because consumers do not significantly reduce their quantity demanded despite the tax.

Analyzing Milk

Milk is a necessity for many households, suggesting inelastic demand. Therefore, an excise tax on milk would likely result in a low deadweight loss, since the purchasing behavior would not change significantly with the imposition of the tax.

Analyzing Diamonds

Diamonds are considered luxury goods with more elastic demand, as consumers can choose not to purchase them if prices rise. The imposition of an excise tax on diamonds would likely lead to a higher deadweight loss, since consumers are more sensitive to price changes.

Analyzing Tropical Vacations

Tropical vacations are a discretionary purchase with elastic demand because consumers are likely to forego a holiday if it becomes too expensive. Therefore, an excise tax here would lead to a high deadweight loss, given the high sensitivity to price changes.

Analyzing Socks

Socks are generally considered necessities and typically have inelastic demand because people continue buying them regardless of small price increases. Therefore, the deadweight loss from an excise tax on socks would likely be low due to the necessity of the product.

Key concepts

Elasticity of Demand

Elasticity of demand is a crucial concept when exploring the economic impact of taxes. It measures how sensitive the quantity demanded of a good is to a change in its price. If demand is elastic, a small price increase leads to a significant drop in quantity demanded. If inelastic, quantity demanded doesn't change much with price changes.

Here are key points about elasticity of demand:

• **Elastic Demand:** When consumers can and do significantly reduce their buying as the price rises, this describes elastic demand. Luxury goods like diamonds often have elastic demand.
• **Inelastic Demand:** Necessities like milk have an inelastic demand. Even with a price increase, people continue buying them almost unabated.

This distinction is vital because it influences how consumers respond to an excise tax, and whether the imposed tax will cause a shift in demand.

Excise Tax

An excise tax is a specific tax levied on certain goods, charged as a fixed amount per quantity. Governments often use excise taxes to influence consumer behavior, such as reducing consumption of harmful products or generating revenue.

Here's what you should know about excise taxes:

• **Purpose:** Excise taxes can be designed to deter the consumption of goods like alcohol. Since such goods often have inelastic demand, these taxes may not drastically reduce consumption but can still generate substantial revenue.
• **Impact on Price:** The seller usually adds the tax to the price of the product, making it more expensive for the consumer.
• **Economic Implications:** Depending on the elasticity of demand for the taxed good, excise taxes can lead to different levels of deadweight loss.

In markets where consumer demand is elastic, an excise tax can lead to a considerable decrease in quantity sold as consumers move away from the taxed product due to price increases.

Economic Efficiency

Economic efficiency refers to the optimal allocation of resources where goods and services are distributed such that any change to assist one party would harm another. Excise taxes, however, can disrupt this efficiency.

Here's how excise taxes relate to economic efficiency:

• **Deadweight Loss:** This occurs when a tax prevents the market from reaching its equilibrium. The loss in economic efficiency is usually more significant if the demand is elastic, as seen with goods like tropical vacations.
• **Influence of Elasticity:** An understanding of elasticity helps predict the extent of deadweight loss. For goods with inelastic demand, like socks or milk, taxes slightly disturb efficiency. In contrast, when demand is elastic, losses in efficiency are higher because of large drops in consumption.
• **Long-term Effects:** While taxes can lead to short-term inefficiencies, they may guide consumers toward socially beneficial purchasing habits.

In summary, when designing taxes, it's essential to consider both the immediate financial impact and the longer-term effects on resource allocation and consumer behavior.