Question

The efficiency loss of imposing an excise tax is due to: \(L O 20.7\) a. Paying a higher price per unit. b. Producing and consuming fewer units.

Short answer

Efficiency loss is due to producing and consuming fewer units.

Step-by-step solution

Understand the Concept of Efficiency Loss

Efficiency loss, often referred to as deadweight loss, occurs when an economic transaction is not mutually beneficial to both the producer and the consumer. This is typically due to an external factor like a tax that causes a certain number of transactions to no longer occur, reducing the overall economic welfare.

Analyze the Effect of Excise Tax

An excise tax is a tax imposed on a specific good or service. When the tax is placed on a good, it increases the overall price of the good from the consumer's perspective, while the producer receives less for the good after the tax is accounted for.

Determine the Source of Efficiency Loss

Efficiency loss arises because the imposition of a tax leads to reduced transactions of the taxed good. When a tax is applied, the price consumers pay rises, and the effective price for producers falls. This situation discourages both consumption and production due to the higher cost and reduced revenue, respectively.

Conclusion

The fewer transactions result in a loss of potential trades that could have been mutually beneficial to both producers and consumers. Thus, the efficiency loss is due to reduced consumption and production rather than just paying a higher price per unit.

Key concepts

Understanding Deadweight Loss

Deadweight loss occurs when resources are not allocated optimally, leading to missed opportunities for economic transactions. This inefficiency can happen when an excise tax is imposed on goods and services, making them more expensive. As a result, fewer people are interested in buying these taxed goods, and producers might also cut back on supply. Imagine a simple graph where demand and supply intersect to show the equilibrium price and quantity. Adding a tax shifts the supply curve upwards, meaning at every price point, consumers receive less quantity.

This shift leads to a new equilibrium point with a higher price for consumers and a lower price received by producers. Consequently, the quantity bought and sold decreases, and this reduction in market activity translates to deadweight loss. It is the shaded area on a supply and demand graph between the old and new equilibrium quantities.

• Deadweight loss arises due to distorted market incentives.
• It represents economic inefficiency.
• Both consumers and producers suffer from lost opportunities.

Impact on Economic Welfare

Economic welfare refers to the overall well-being or prosperity of a society in terms of its economic health and wealth distribution. The imposition of an excise tax directly affects economic welfare as it leads to an alteration of resource allocation in the market. This change does not necessarily improve the welfare but often redistributes it unevenly.

In many cases, consumers face higher prices due to the tax, which means they have less purchasing power. Producers face reduced sales and may earn less revenue, making it harder to sustain their businesses. This situation can inadvertently widen the gap between rich and poor, as those with higher incomes are often better able to absorb increased costs.

• Taxes affect purchasing patterns.
• Resource allocation changes can reduce market efficiency.
• Long-term welfare may decline if taxes impede innovation and growth.

Tax Impact on Consumption and Production

When an excise tax is levied, both consumption and production undergo significant changes. The immediate effect is a shift in consumer behavior as they respond to higher prices. Higher prices typically discourage consumption, prompting consumers to either reduce the quantity they buy or switch to alternative, untaxed goods. For example, if a tax raises the price of sugary drinks, some people might choose water or other non-taxed drinks instead.

On the production side, manufacturers might find their revenues declining due to reduced sales volume. This decline can lead them to decrease production, lay off workers, or cut costs in other areas. This reduction in activity reflects a drop in economic output, meaning the economy may not be utilizing its full productive capacity.

• Consumption decreases when prices rise due to taxes.
• Producers may produce less and earn less revenue.
• Overall economic productivity can be negatively impacted.