An efficient market generates equality between demand price, the value of the good produced, and supply price, the value of goods not produced. Placing a tax on the good, service, or activity exchanged through an efficient market necessarily disrupts this equality between demand price and supply price. In particular it drives a wedge between the two prices.

This tax wedge means that buyers and sellers each generally pay a portion of the tax and is the source of inefficiency. The incidence of a tax, that is, how much of the tax is paid by buyers and how much by sellers, depends on the demand and supply prices before the tax compared to after the tax. Inefficiency arises a tax causes an overall decrease in consumer surplus and producer surplus. A portion of the consumer and producer surplus that exists in an untaxed is transferred to government as the tax, which can then be used to finance government operations. However, a portion of this surplus also simply disappears. Society gains nothing in return for this lost surplus.

An Efficient Market

An Efficient Market

This equilibrium is efficient because the demand price and supply price are equal at $3. 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.

The Tax Wedge

For this reason, we can identify a new "supply" curve that is the original supply curve plus the tax. For ease of exposition, let's say that a per unit tax of $1 is added to supply. 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. 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.

Before getting to the new equilibrium achieved with the tax, take a closer look at exactly what the tax does. The tax drives a "wedge" between the price buyers pay (the demand price) and the price sellers receive (the supply price). The demand price is the price corresponding with the demand curve (D) and the supply price is the price corresponding with the original supply curve (S).

To illustrate this tax wedge, click the [Tax Wedge] button. Doing so highlights that a $1 per unit tax effectively creates a $1 difference between the demand price and supply price. This position of this wedge effectively determines the after-tax equilibrium for this market.

Tax Incidence

Tax Incidence

The next step is identify the market equilibrium achieved after the tax is imposed on the market. This is found at the intersection of the original demand curve (D) and the new "supply curve" (S + T). A click of the [Equilibrium] button reveals this result.

The market achieves equilibrium with a price of $3.50 and a quantity of 3.75. The result of this per unit tax is a higher price and a decrease in the quantity exchanged, just like any decrease in supply. In fact, the inclusion of a tax has much the same affect on a market as an increase in any resource price. The price goes up and the quantity goes down.

However, while the market equilibrium price is higher and the buyers are paying a higher price to purchase this good, the sellers are not receiving this higher price. Part of the higher price goes to government as the tax. So, who is really paying the tax? Buyers? Or sellers?

Who Pays?

• Demand Price: The demand price is the price paid by the buyers at the new equilibrium intersection of the demand curve, D, and the new supply curve, S + T, a price of $3.50. This is the maximum price that buyers are willing and able to pay for the new equilibrium quantity.


• Supply Price: The supply price is the price received by the sellers, which is the difference between the new equilibrium price ($3.50) and the tax ($1), or $2.50. This is the minimum price that sellers are willing and able to accept for the new equilibrium quantity.

In this example, $0.50 of the $1 per unit tax is paid by buyers and $0.50 is paid by sellers. A tax is seldom equally divided among buyers and sellers, as in this simplistic example. The actual tax incidence is based on the shapes, slopes, and elasticities of the demand and supply curves.

Deadweight Loss

Deadweight Loss

This transfer is NOT the source of the inefficiency. Something else is a work.

A Lot of Surplus

• 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 demand 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.

This difference is termed deadweight loss. The deadweight loss triangle simply vanishes when a tax is imposed on the market. It is a loss incurred by society. Resources are not being used to generate the greatest possible satisfaction.

An Inefficient Start