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4. The Laffer curve

Government-imposed taxes cause reductions in the activity that is being taxed, which has important implications for revenue collections.

To understand the effect of such a tax, consider the monthly market for cigarettes, which is shown on the following graph.

Use the graph input tool to help you answer the following questions. You will not be graded on any changes you make to this graph.

Note: Once you enter a value in a white field, the graph and any corresponding amounts in each grey field will change accordingly.

0102030405060708090100109876543210PRICE (Dollars per pack)QUANTITY (Packs)Demand Supply

Graph Input Tool

Market for Cigarettes
	Quantity (Packs)
	Demand Price (Dollars per pack)			Supply Price (Dollars per pack)
	Tax (Dollars per pack)

Suppose the government imposes a $2-per-pack tax on suppliers.

At this tax amount, the equilibrium quantity of cigarettes is

packs, and the government collects

in tax revenue.

Now calculate the government's tax revenue if it sets a tax of $0, $2, $4, $5, $6, $8, or $10 per pack. (Hint: To find the equilibrium quantity after the tax, adjust the Quantity field until the Tax equals the value of the per-unit tax.) Using the data you generate, plot a Laffer curve by using the green points (triangle symbol) to plot total tax revenue at each of those tax levels.

Note: Plot your points in the order in which you would like them connected. Line segments will connect the points automatically.

Laffer Curve012345678910200180160140120100806040200TAX REVENUE (Dollars)TAX (Dollars per pack)

Suppose the government is currently imposing a $3-per-pack tax on cigarettes.

True or False: The government can raise its tax revenue by increasing the per-unit tax on cigarettes.

True

False

Consider the deadweight loss generated in each of the following cases: no tax, a tax of $4 per pack, and a tax of $8 per pack.

On the following graph, use the black curve (plus symbols) to illustrate the deadweight loss in these cases. (Hint: Remember that the area of a triangle is equal to 12BaseHeight12BaseHeight. In the case of a deadweight loss triangle found on the graph input tool, the base is the amount of the tax and the height is the reduction in quantity caused by the tax.)

Deadweight Loss012345678910200180160140120100806040200DEADWEIGHT LOSS (Dollars)TAX (Dollars per pack)

As the tax per pack increases, deadweight loss .

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