This week we are doing some real economics.
We said that the free market maximises the delivery of social surplus. This week we consider three factors that move a market away from its free market equilibrium:
Price floors – minimum prices that prices cannot fall below e.g. minimum wages.
Price ceilings – maximum prices that prices cannot exceed e.g. rent controls.
Excise or sales taxes – taxes levied as some fraction of the price of a good.
In all these situations social surplus is reduced below its free market levels – this means there are deadweight losses. That is true even when, in the case of taxes, we account for benefits to governments from tax revenue. These are important results and you need to be able to show that they are true by drawing supply/demand diagrams and computing the DWLs.
You should also understand the intuition of what they are true – all these distortions place a barrier between groups of buyers and sellers of a good or factor of production like labour.
These results lie at the core of why it is that economists like free trade when there is competition.
We analyse sales taxes in detail.
When taxes are low, DWLs are low as are revenue yields. As taxes increase DWLs increase more quickly than the tax and tax revenues first increase and then decrease as demands become more elastic.
This provides a case for trying to keep taxes low.
We also discuss the Laffer curve which suggests that if labour supplies are very price elastic that reducing high taxes might actually increase revenue yields.
Most people believe the Laffer analysis holds only in extreme situations.