How Can Taxes on a Good Affect Both Consumer Surplus & Producer Surplus?
Economic surplus is made up of two elements: consumer surplus, which is money buyers would be willing to spend to buy a good above what they must pay at the current price; and producer surplus, which is money the producers are making at the current price above what they would be willing to accept to still stay in the market. Imposing a tax distorts the interaction of demand and supply, with the effect of reducing both consumer surplus and producer surplus for the good.
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Consumer Surplus
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Consumer surplus is the difference between the market price of a good and the highest amount consumers would be willing to pay for it. It comes about because every consumer has his own maximum price he would be willing to pay for a good, but the market aggregates this demand, along with supply, to produce a market price.
Consumer surplus comes about because demand is rarely perfectly elastic: For most goods there is a limit to how much or how little consumers will buy, no matter how much the price changes. For example, people are unlikely to stop buying bread if the price rises, and they are unlikely to buy a lot more bread if the price falls.
In effect, consumer surplus can be seen as the total use or value that consumers get without paying for it.
Producer Surplus
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Producer surplus is the other side of the coin. It represents the difference between the market price and the lowest amount for which producers would be willing to sell a good.
It is possible -- and, in fact, normal -- that there will be consumer surplus and producer surplus for the same good. In the same way each consumer has her own maximum price for a good, each producer has a minimum price for the good. In most cases, this is at or slightly above the producer's costs, because there is no benefit to producing and selling more cheaply than this. In effect, producer surplus means profit.
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Tax Effects: Demand and Supply
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Putting a tax on a good distorts the relationship between demand and supply. This is because, if the good is taxed, the amount consumers pay would be higher than the amount producers receive. Starting from any particular price, the quantity consumers are willing to buy is, therefore, higher than the quantity producers are willing to produce.
In most cases, the market mechanism will produce a compromise to solve this disparity, usually in the form of a rise in the price and a fall in the quantity sold. With some taxes, such as those on cigarettes, the government introducing the tax will view this as beneficial.
Tax Effect: Economic Surplus
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The addition of the tax will remove some consumer surplus and some producer surplus. Consumers are forced to pay more for the same good because the price has risen. Meanwhile, producers are losing out on potential profits because their revenue has not increased by as much as the price rise would suggest.
Jose State University economics professor Thayer Watkins, among others, suggests the direct financial benefit a government gets from the tax revenue is slightly lower than the combined loss in economic surplus, thus meaning a loss to the economy as a whole. Counter arguments include the possibility that the government may be able to bring about a greater economic benefit in the way it spends the tax revenue, and political or social benefits may result from the effect the tax has on buying habits.
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