In an efficient, competitive market, free of market control, equilibrium is achieved with equality between the demand price and supply price. At this equality buyers pay the same price that sellers receive. The sellers use this revenue then to pay the myriad opportunity costs of production. However, when a tax is placed on the market, the demand price paid by buyers must cover not only the supply price, the sellers' opportunity costs of production, but also the tax. This difference between demand price and supply price is the tax wedge.

An Efficient Market

An Efficient Market

The equilibrium quantity is achieved with equality between the quantity demanded and the quantity supplied. Buyers are able to buy all of the good that they want to buy at the equilibrium price and sellers are able to sell all of the good that the want to sell at the same equilibrium price. Moreover, the demand price that buyers are willing to pay at the equilibrium quantity exactly matches the supply price that sellers are willing to receive at the same equilibrium quantity. Both sides of the market are satisfied with the exchange.

Absent market failures such as market control, externalities, public goods, or imperfect information, then this equilibrium is also efficient. Equality between the demand price and supply price means that the value of the good produced is equal to the value of goods not produced. It is not possible to produce more or less of this good such that society's level of satisfaction increases.

Adding a Tax

Whatever the collection process, the consequence for market equilibrium is the same. Buyers end up paying a higher price than sellers receive (or get to keep). This difference in demand price and supply price is the tax wedge.

The easiest way to graphically illustrate a tax wedge is from the supply side of the market -- to treat the tax as a cost of production. While a tax is not really an opportunity cost, from the economy's perspective, if paying the tax is the responsibility of the suppliers, then it can be viewed as a "cost of doing business" for the suppliers. The sellers collect the tax revenue from the buyers, then have the responsibility of making payment to government.

With this approach, we can identify a new "supply" curve that is the original supply curve plus the tax. This works much the same way as a change in the resource prices determinant of supply.

To facilitate the exposition, let's say that a per unit tax of $1 is added to supply. The results are essentially the same if an ad valorem tax is imposed. The result is a new "supply" curve, which lies above and to the left of the original supply curve. This new supply curve, labeled S + T, can be revealed by a click of the [Add the Tax] button. Again, the inclusion of a tax has much the same affect as an increase in any resource price or the cost of production, technically termed a decrease in supply.

The Tax Wedge