Question

Suppose that a market is described by the following supply and demand equations:

Q^S = 2P

Q^D = 400 - 3P

Suppose that a tax of T is placed on buyers, so the new demand equation is

Q^D = 400 – 3(P+T)

Solve for the new equilibrium. What happens to the price received by sellers, the price paid by buyers, and the quantity sold?

Tax revenue is T x Q. Use your answer from part (b) to solve for tax revenue as a function of T. Graph this relationship for T between 0 and 400.

The deadweight loss of a tax is the area of the triangle between the supply and demand curves. Recalling that the area of a triangle is 1?2xbasexheight, solve for deadweight loss as a function of T. Graph this relationship for T between 0 and 400. (Hint: Looking sideways, the base of the deadweight loss triangle is T, and the height is the difference between the quantity sold with the tax and the quantity sold without the tax.)

The government now levies a tax of $300 per unit on this good. Is this a good policy? Why or why not? Can you propose a better policy?

Answer 1