Question

6. Consider 2 markets, pharmaceutical drugs and computers. Demand for pharmaceutical drugs is inelastic while the demand for computers is elastic.

a. Now suppose that the government were to place a tax in both markets. Which market has a larger dead weight loss from taxes?

b. Which market generates a larger tax revenue?

c. Given your answers to b. and c., is it more efficient to tax pharmaceutical drugs or computers? It is more equitable to tax pharmaceutic drugs or computers? Balancing the concepts of equity and efficiency, which market would you tax and why? (Note: for the last part there is no right or wrong market to tax. I am looking for an argument that is based on the concepts of equity and efficiency. )

Answer 1

A) Taxes impose a larger deadweight loss in markets having elastic demand.

This is because when demand is elastic, quantity changes more with respect to price change, leading to greater deadweight loss.

Thus, the market for computers will have a greater deadweight loss.

B) Tax revenue is higher in case of inelastic demand, as quantity falls less with respect to price increase due to taxation in case of inelastic demand.

Thus, the market for pharmaceutical drugs would give higher tax revenues.

C) It will be more efficient to tax the market which yields lower deadweight loss.

That is, the market for pharmaceutical drugs must be taxed in order to make deadweight loss minimal and achieve higher efficiency.

With respect to equity, it would be more equitable to tax computer market, as it would lead to lower tax revenue and thus less market distortion.