Question

Toward the end of the chapter, it was pointed out that a tax on labor income can cause a deadweight loss, just like an excise tax on a good. a. Draw a diagram of a labor market in which the equilibrium wage is \(\$ 20\) per hour and total employment is 10,000 workers. On the graph, identify an area that represents total benefits to workers. (Hint: This area will be analogous to producer surplus in a goods market. Think about each point on the labor supply curve, and ask: What is the lowest wage at which this worker would supply labor, compared to the wage they are actually being paid?) b. On the same graph, identify an area that represents total benefits to firms from hiring labor. [Hint: This area will be analogous to consumer surplus in a goods market. Think about each point on the labor demand curve, and ask: What is the highest wage the firm would pay to hire this particular worker, compared to the wage it is actually paying?] c. Draw a second diagram showing the impact of a \(\$ 10\) per hour tax on labor income, collected from workers. On this diagram, identify areas that represent, after the tax, each of the following: (1) the total benefits to workers, (2) the total benefits to firms, (3) the government's tax revenue, and (4) the deadweight loss from the tax.

Short answer

The diagrams illustrate the labor market before and after the imposition of a $10 labor tax. The first diagram delineates the total benefits for workers and firms. The second diagram shows the reduced benefits to workers and firms due to the tax, the government's tax revenue, and the deadweight loss caused by the tax.

Step-by-step solution

Drawing the Initial Labor Market

Draw a graph with wage on the vertical axis and quantity of labor on the horizontal axis. Plot a downward-sloping demand curve and an upward-sloping supply curve. Mark the point where these curves intersect as the equilibrium, with a wage of $20 and quantity of 10,000 workers.

Identifying Total Benefits to Workers

On the previously drawn graph, the total benefits to workers or 'producer surplus' is represented by the area above the supply curve (representing the labor market's minimum acceptable wage) but below the wage line (representing what the worker is actually being paid). Shade this area to illustrate total benefits to workers.

Identifying Total Benefits to Firms

On the same graph, the total benefits to firms or 'consumer surplus' is the area below the demand curve (representing the highest wage firms would be willing to pay) but above the wage line (representing what they are actually paying). Shade this area to illustrate total benefits to firms.

Drawing the Imposition of a Labor Income Tax

Draw a new diagram similar to the previous one, but now include the imposition of a $10 per hour tax on labor income. This results in a new supply curve that is $10 higher than the original. Note that the new equilibrium wage that firms pay is lower, while the wage that workers receive (after tax) is even lower.

Identifying Areas After Tax

On this diagram, several areas can be identified. The total benefits to workers (after tax) is lower and represented by the new area above the supply curve but below the new wage line. The total benefits to firms is represented by the area below the demand curve but above the new wage line. The government's tax revenue is represented by a rectangle, with height equivalent to the tax and width equivalent to the quantity of employed workers after the tax. Lastly, the decrease in total benefits to workers and firms represents the deadweight loss caused by the tax - this is indicated by the triangle between the original and new supply curves.