Dr.

Ummad Mazhar
SDSB, LUMS
Principles of Microeconomics
MECO111
Session 12

MECO111 Fall2024 1
Meaning of efficient allocation
• Efficient allocation of resources:
• No profitable trade is possible when market reaches
equilibrium
• All the opportunities of profitable trade are exhausted
• No individual can be made better off without making
someone else worse off
• All the agents are doing their best

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Efficiency and inequality
• Efficient allocation of resources does not mean fair
allocation of resources
• Maximum CS goes to the consumer that has
greatest willingness to pay
• Maximum PS goes to the supplier who has least cost
of production

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 Tax burden

• In Pakistan, the average income tax collected from a businessperson under the
Tajir Dost Scheme (TDS) is around Rs2,432 per month. [Dawn, https://www.dawn.com/news/1855386]

• Despite contributing 20pc to the gross domestic product, the tax contribution
of the retail and wholesale sector stands at a mere 4pc. The government has
been striving for years to effectively bring this sector into the tax net.

• Only 300,000 of an estimated 3.5 million retailers are actively filing tax returns.
The TDS aims to bring the remaining 3.2m into the tax net.
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 Welfare cost of taxation

• Taxes are what we pay for civilized society.

• We can use concepts of consumer and producer surplus to measure the

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Dead weight loss of taxation
• In competitive markets, tax
burden is shared by both the
consumers and producers
irrespective of who is being
taxed, as long as the demand
and supply curves follow their
usual shapes.
• This diagram is not showing any
shift in demand or supply i.e.,
who is being taxed by the
government.
• It is only showing the main
consequence of tax: it creates a
gap between what consumers
pay and what suppliers receive.
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Tax revenue
• If government imposes a tax of
Rs. 2 per unit sale of a
commodity
• If the commodity has 500 units
sold
• Then tax revenue would be
TaxPerUnit*UnitsSold = 2*500 =
1000

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Welfare effects of tax
• Without tax:
• CS = ?
• PS = ?
• Tax revenue =
• Total Surplus = ?
• With tax:
• CS = ?
• PS =
• Tax Revenue =
• Total Surplus =
MECO111 Fall2024 8
Welfare and taxes

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 Class exercise
Consumer Willingness to Pay Producer Cost
A 70 Z 10
B 60 Y 20
C 50 X 30
D 40 W 40
E 30 V 50

Assume that each consumer buys at most one pizza; each producer sells at most one pizza. The
government asks your advice about the effects of an excise tax of Rs. 40 per pizza. Assume that
there are no administrative costs from the tax.
1. Without the excise tax, what is the equilibrium price and the equilibrium quantity of pizza
transacted?
2. The excise tax raises the price paid by consumers post-tax to Rs. 60 and lowers the price
received by producers’ post-tax to Rs. 20. With the excise tax, what is the quantity of pizza
transacted? MECO111 Fall2024 10
 Quick quiz
• Donna runs an inn and charges $300 a night for a room, which equals her
cost. Sam, Harry, and Bill are three potential customers willing to pay $500,
$325,and $250, respectively. When the government levies a tax on
innkeepers of $50 per night of occupancy, Donna raises her price to $350. The
deadweight loss of the tax is
• a. $50.
• b. $100.
• c. $25.
• d. $30.

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 Dead weight loss and elasticity
• What determines whether the deadweight loss from a tax is large or small?
The answer is the price elasticities of supply and demand
• A tax has a deadweight loss because it induces buyers and sellers to change
their behavior.
• The more responsive buyers and sellers are to changes in the price, the
more the equilibrium quantity shrinks.
• Hence, the greater the elasticities of supply and demand, the larger the
deadweight loss of a tax.
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Supply elasticity and dead-weight loss

13
MECO111 Fall2024
Demand elasticity and dead-weight loss

MECO111 Fall2024 14
 Tax revenue and dead-weight loss
• What happens to the deadweight loss and tax revenue when the
size of a tax changes?
• The size of the dead-weight loss increases with the size of the tax
• Importantly, the rate at which dead-weight loss increases is higher
compared to the rate of tax increase
• Thus if government increases the size of its tax, its tax revenue
increases initially but falls eventually
• This is called Laffer curve (named after economist Arthur Laffer)

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Size of tax and the size of dead-weight loss

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Dead weight loss and tax revenue in the long run

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Chapter 5

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Question
• Suppose that demand is Qd = 300 – P and supply is Qs = 0.5P – 30.
• 1. What is equilibrium price and quantity in this market?
• 2. What is the effect of a unit tax T = 15, if imposed on sellers.
• 3. What is the government tax revenue.

• Solution: Qd = Qs
• 300 – P = 0.5P – 30
• 330 = 1.5P
• 220 = P
MECO111 Fall2024 19
Solution
• (b) After tax the price that buyers pay is Pb = Ps + 15
• Ps is the price that sellers receive
• After tax Qd = 300 – Pb and Qs = 0.5P – 30
• Qd = Qs
• 300 – Ps - 15 = 0.5Ps – 30
• 300 – 15 + 30 = 1.5Ps
• 315 = 1.5Ps
• 210 = Ps
• Pb = 210 + 15 = 225
MECO111 Fall2024 20
Solution (c)
• Tax revenue
• Qd in the market: Qd = 300 – Pb  300 – 225 = 75
• Tax per unit times quantity traded in the market gives us tax revenue
• Q*T
• 75 * 15 = 1125

MECO111 Fall2024 21
MCQs
p
S

q* q

MECO111 Fall2024 22
1
• A. Quantity demanded is independent of price
• B. Demand depends on supply
• C. Quantity supplied is fixed and independent of price
• D. Market equilibrium quantity depends on demand

MECO111 Fall2024 23
2.
p

p* S
D

MECO111 Fall2024 24
 2.
a. Market equilibrium is not possible
b. Supply depends on a unique price such that any
deviation from it leads to zero quantity supplied
c. Quantity supplied determines equilibrium quantity
exchanged
d. Quantity exchanged is not the equilibrium quantity

MECO111 Fall2024 25
3.
p

p*+t S’
p* S

MECO111 Fall2024 26
If t indicates per unit tax on sellers, then
a. Tax is shared equally by buyers and sellers
b. All tax is paid by consumers because they have elastic
demand
c. All tax is paid by consumers because supply is possible only
at a unique price of p*
d. All tax is paid by suppliers because supply is possible only
at a unique price of p*

MECO111 Fall2024 27
4.
p
S

p*
D
q* q

MECO111 Fall2024 28
With reference to graph on the last slide, if govt
imposes a fixed per unit tax on sellers then
a. It is shared equally by consumers and suppliers
b. All tax is paid by suppliers because demand is inelastic
c. All tax is paid by suppliers because government has not
imposed tax on consumers
d. All tax is paid by suppliers because quantity supplied is fixed
and independent of price

MECO111 Fall2024 29
5.
• In MCQ4 the price received by suppliers is
a. Above the equilibrium price
b. Same as the equilibrium price
c. Below the equilibrium price by the amount of tax
d. Cannot be determined from the given information

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Key
1. Ans: C
2. Ans: B
3. Ans: C
4. Ans: D
5. Ans: C

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See you next time

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