What are the determinants of the Deadweight Loss?
Introduction
The deadweight problem happens when the government through an attempt to increase their earnings from the goods in a country increases the taxation on them. It happens when they impose a certain amount of tax on certain commodities in the market and the end consumer as well as the producer in charge of the production process forced to lose the whole or part of their surplus. The loss they both suffer is the deadweight loss. The government has the right to earn some form of income from the trade activities within their borders. However, they also need to take precaution and reduce the amount of taxes on the goods (Hall and Lieberman, 2012 p100). The deadweight loss may also vary depending on the type of good and the urgency in which the clients need the sound which means that the commodities commonly used by customers attract a high amount of tax. There is also a direct relationship between the tax revenues earned by the government and the tax rates which indicate that the more tax-induced on a commodity, the more the amount of money those customers are willing to pay. They may also need to meet other hidden costs from the amount of tax as the prices of the good or commodity are plotted in one way or another. Deadweight loss is also the burden experienced by the power of the monopolistic market and the acts of taxation on a product. There is a loss in the financial ability as well as the efficiency of the same and occurs at any time when there is a high level of equilibrium affecting the good or service which becomes unattainable.
There are many determinants of deadweight, and they vary depending on the trigger for such an action (Salanie, 2011 p108). One of the triggers is the monopolistic power that firms have since they are the only suppliers in the market and they are in a position to take advantage of the customers. Another factor is when the government tends to control the cost of goods, services or products due to the amount of money in revenue they stand to gain while the other factor is the externalities. The externalities are diverse and may depend on the value added on a commodity before it becomes an end product. For the purpose of this study, the research will focus on the three factors.
Taxes imposed by governments
Taxes are one of the ways through which the government earns their income. It has the advantage of determining the amount of tax charged on goods and services as well as the trade activities happening within their borders. It is also an illustration that the government is in control and oversees every trade and economic activity that happens in their country. The deadweight determinants are either big or small, depending on the price elasticity of the supply and the demand of the products in the market. It is the measure of the relationship that exists between the quantity demanded and the quantity available for the supply and how they respond to the changes in the pricing of the products. Hence, when the elasticity of the price is high, then the deadweight loss of the tax is greater than when there is some level of price inelasticity which indicates that it becomes smaller. In simple terms, when the market responds to the change in an increase or decrease in the price of a commodity, it reflects their response to the amount of tax imposed on the product (Saez et al., 2012 p33). If the tax rate is very high, then only a few numbers of people who are ready and willing to purchase the price at the current price. In an extreme situation, the elasticity of the demand in a perfectly elastic market, there is no change in the quantity demanded by the customers as it feels no effect due to the changes in taxation. The result, in this case, is that there is no deadweight loss on the market.
There is a direct relationship between the deadweight loss and the rate of tax signifying that any increase in the rate of the tax causes a direct and equal move in the deadweight loss. The higher the tax, the higher the deadweight loss and the implications of the same on the quantity supplied in the market (Feldstein, 2008 p99). The government earns a reduced amount in returns once the tax imposed on the market has reduced hence the revenues decrease significantly. When the tax rate increases, then there is an increase in the revenue earned. However, this is applicable up to a certain point where the growth in tax may have an adverse effect since it means that the prices of products increase in the market. Therefore, only a small number of people in the market are ready and willing to purchase the product at that price. The taxation effect by the government on the deadweight loss and the products is that it stands to gain more and have an increased amount of revenues from the collected taxes in the products.
Figure 1: Changes in the price and quantity demanded based on the amount of taxation imposed on a product by the government (Piketty and Ganser, 2014 p129)
The market acts and responds to the sum of money they are ready and willing to part with so that they can get a particular product. When a product is an essential, and there are no substitutes for the commodity in the market, then they have no choice but take the price at what the firm's charge (Piketty and Ganser, 2014 p128). The companies, on the other hand, use and charge a high price of the products as they have to meet the cost of production, whereas the government enjoys the largest share in the returns due to the high rate of taxes they impose of products. The higher the tax, the less the quantity demanded and the higher the price since the firms and the government need to come close to an agreement on the amount of money that each stands to gain at the end of the business transactions.
Monopoly
Some firms have the absolute power in that they are the only suppliers of a commodity in a market and them, therefore, have the power to set the prices as they control the market. The clients do not have an option or the bargaining power to which they can have one voice to advocate for the reduction of prices charged (Lee and Brown, 2008 p67). Hence, the deadweight loss in the monopolistic environment arises when a firm manages to set the minimum price of the commodities over and above the marginal cost. It means that there existed a large gap between the minimum and recommended the amount that they should charge the consumer and the cost of production that the producer meets. It is okay to have a price set for a product, and the pricing depends on the factors of production which makes the product affordable due to the set price. The differences between the cost and the price of the producer bring about a difference in the number of goods sold which may either be an increase or a decrease. Since the market does not have an option in the industry and the firm with the monopoly power is the only solution they have, then they have no choice but to accept the pricing from the market (Simpson and Wickelgren, 2007 p1306). It means that the firm with the monopoly power gets the chance to enjoy the profits and in some cases may be supernormal profits. The differences arise in the type of product they sell meaning that a commodity that the market uses on a daily basis tends to attract supernormal profits than the others.
The firm is also in a position to understand the economic strength of their market and may practice the price discrimination move on the customers. It happens when they charge different prices for the same type of product in the market, which helps in bridging the gap and reducing the deadweight loss. It also helps in increasing the profits of the monopolist. A deeper explanation and result in the deadweight loss in the monopolistic market happens when there is an increase in the output in the quantity on the price which brings about equality to the marginal cost charged to the market. Hence, the result of this is that there is an increase in the economic profits that a firm enjoys when there is a single monopoly in the market. Therefore, the deadweight loss elimination takes place.
Figure 2: The figure above is an illustration of the marginal costing intersection with the demand and supply that occurs in a monopoly market. It also indicates that the marginal revenue is equal to the request, the price and the aggregate demand as well (Simpson and Wickelgren, 2007 p1306)
Figure 3: the figure was suggesting the changes in the monopolistic and their ability to earn profits in the market (Smart, 2007 p188).
Externalities
An externality takes place in an economical set up when the benefit or costing touches on an end party that had no intention of enjoying the benefit or meeting the expenses in the process. The externality aspect happens in two ways, a positive and a negative and both do not occur at the same time. The government through the economists attempt to formulate and reform the business world so that policies in the industry may cause the parties which make a choice to feel the burden of the cost or the benefit of profits to feel the effect as an externality. In the production process, the prices of raw materials may increase after a firm had already made a purchase hence may not have an effect on them. They, however, want to take advantage and impose the costs on the end consumer where they want them to meet the cost of production so that they can enjoy supernormal profits (Smart, 2007 p188).
Another instance happens when the pollution effect of an organization may require it some form of environmental costs that necessitates the entity to take the right measures to reduce the impact. In severe cases, they may need to pay a considerable amount of money to the public as settlement claims, whereas the public is aware that they should not leave near mechanical and chemical plants due to the implications on their health. In the long run, the organization produces less of their end product at the expense of the public safety and the governmental regulations. Therefore, the externality, in this case, happens at the possibility of the firm in increasing costs and the environment and the market benefitting double from the products in the market and the amounts in settlement claims as well. The externality representation in the demand and supply curve indicates that a change in either has repercussions in the increased consumption of production of the right in question (Kumar, 2008 p248).
Figure 4 (Kumar, 2008 p248)
Figure 5: (Kumar, 2008 p248)
One of the curves in the diagram is an illustration and a representation of the costs which the consumers are willing to pay for any additional good they receive as part of the added quantity. It may necessitate the need to have an increased level of supply of goods flowing in the market and those in the hands of the consumers and the producers who are the suppliers in this case (Chetty, 2009 p51). The added curve on the side represents the response that the market has in some goods in circulation as well as those that they will consume. A positive externality happens when the expected deadweight loss curve reduces, and there is an increase in the demand for the products. The quantities demanded may also have a significant increase depicting the effects on the consumers as positive and dependable. A positive externality effect on the market signifies that the industry protects the consumers and shields them from any form of negative effect on the products.
Conclusion
The deadweight loss is an economic effect, and there is a high need to find a balance so that the end consumers do not have to meet the blunt disadvantages of the costs in production. The actions of the government in increasing the taxes should happen on non-essential goods which the customers do not need on a daily basis. They may need to meet part of the costs or reduce the tax rate so that a large number of people can enjoy the services in the market. On the other hand, there is a need to impose the tax so that they can earn some form of revenue. The government also needs to step in and regulate the monopolistic market, which tends to overcharge the customers based on the power they enjoy being the only suppliers in the market. It will also help in minimizing the amount that the monopolies enjoy as a form of profits from the deadweight loss they impose on the end consumer. The issue of externality is a tricky aspect, but as long as the clients have the maximum benefit, then there would be a balance in the market. All activities in the industry should protect the consumer both in the long run and in the near term.
Bibliography
Chetty, R., 2009. Is the taxable income elasticity sufficient to calculate deadweight loss? The implications of evasion and avoidance. American Economic Journal: Economic Policy, 1(2), pp.31-52.
Feldstein, M.S., 2008. Effects of taxes on economic behavior (No. w13745). National Bureau of Economic Research, pp.88-99.
Hall, R.E. and Lieberman, M., 2012. Microeconomics: Principles and applications. Cengage Learning, pp.68-102.
Kumar, A., 2008. Labor supply, deadweight loss and tax reform act of 1986: A nonparametric evaluation using panel data. Journal of Public Economics, 92(1), pp.236-253.
Lee, Y.H.A. and Brown, D.J., 2008. Competition, consumer welfare, and the social cost of monopoly. In Computational Aspects of General Equilibrium Theory (pp. 47-68). Springer Berlin Heidelberg, pp.23-78.
Piketty, T. and Ganser, L.J., 2014. Capital in the twenty-first century, pp.99-138.
Saez, E., Slemrod, J. and Giertz, S.H., 2012. The elasticity of taxable income with respect to marginal tax rates: A critical review. Journal of economic literature, 50(1), pp.3-50.
Salanie, B., 2011. The economics of taxation. MIT press, pp.108-112.
Simpson, J. and Wickelgren, A.L., 2007. Naked exclusion, efficient breach, and downstream competition. The American Economic Review, 97(4), pp.1305-1320.
Smart, M., 2007. Raising taxes through equalization. Canadian Journal of Economics/Revue canadienne d'économique, 40(4), pp.1188-1212.
