Question

After drugs are legalized, the US government should tax their producers, which will result in huge tax revenues. Start with the drug market equilibrium from the previous part and capture the effect of taxes. (Hint: Taxing drug production acts like an additional cost for producers. Keep demand the same and account for taxing by shifting the supply curve accordingly.)

Answer 1

In following graph, D0 & S0 are initial demand and supply curves for drugs, intersecting at point E with initial price P0 and initial quantity Q0.

Consumer surplus (CS) = Area between demand curve and price = Area AEP0

Producer surplus (PS) = Area between supply curve and price = Area BEP0.

The tax will shift supply curve leftward from S0 to S1, intersecting D0 at point F with higher price P1 (which is Price paid by buyers) and lower quantity Q1. Price received by sellers is P2 (where P1 - P2 = Unit tax).

After tax,

CS = Area AFP1

PS = Area BGP2

Tax revenue = Area P1FGP2

Deadweight loss = Area EFG.