However, if the existing allocation is efficient, then taxes can cause an inefficient allocation. This inefficiency can be seen by a difference in the demand price (the value of the good produced) and the supply price (the value of goods not produced). Because efficiency is achieved with equality between these two values, inequality means inefficiency.

Another indication of efficiency and inefficiency is seen through the combination of consumer surplus and producer surplus. Consumer surplus is the extra value buyers receive from a good over and above the price paid. Producer surplus is the extra value that sellers obtain over and above the cost of production. In an efficient market, the sum of consumer and producer surplus is maximized.

Levying a tax on an otherwise efficient market decreases the sum of consumer and producer surplus. A portion of the surplus is simply transfer to government as the tax payment. However, a portion of the surplus is also lost -- it vanishes. This decreased surplus is the deadweight loss of the tax.

A Lot of Surplus

Deadweight Loss

• Consumer Surplus: This is the difference between the maximum price buyers are willing to pay for a good and the price actually paid. Graphically, it is the area above the price and below the demand curve. To highlight the consumer surplus for this market, click the [Consumers Surplus] button.


• Producer Surplus: This is the difference between the minimum price sellers are willing to accept for a good and the price actually received. Graphically, it is the area below the price and above the supply curve. To highlight the producer surplus for this market, click the [Producers Surplus] button.

Enter the Tax

• First: A portion of consumer surplus and producer surplus is transferred to government as tax revenue. This is not necessarily inefficient, so long as government uses this revenue for valuable production. To illustrate this transfer of tax revenue, click the [Tax Revenue] button. This is the yellow rectangle given by the difference between the demand price and supply price, which is the $1 tax, and the new quantity exchanged, which is 3.75 in this case.


• Second: A portion of consumer surplus and producer surplus is lost, it simply vanishes, ceases to exist. This is termed deadweight loss. To illustrate this loss, click the [Deadweight Loss] button. This is the small yellow triangle between the old and new equilibrium quantities and the demand and supply curves.