Relationship Between Economic Incidence and DWL

Economic incidence and deadweight loss (DWL) are obviously related and the first argument in this sense is purely intuitive. Taxation represents a burden that the consumer or the producer will need to support (usually, it will be somehow shared, not necessarily in an equal manner, between the two). Other than formal incidence, namely who actually is legally required to pay the tax, economic incidence will tell who suffers the actual burden of paying the tax.

Deadweight loss, on the other hand, is "the reduction in the total surplus that results from a policy that prevents mutually beneficial trades from occurring" (Whitman, n.a.). So, intuitively, one can assume that taxation and economic incidence, respectively, can actually cause deadweight loss. It is also likely that the correlation can go further, in the sense that one could potentially numerically quantify the relationship and show that an increase with x % in economic incidence will also result in a y % change of the deadweight loss.

The graphic below will discuss the effect of raising taxes on a pack of cigarettes and will also show graphically where deadweight loss will be formed. The price of a pack of cigarettes is $2.50 and is shown as P*. The government adds $1 in tax, which means that the supply curve will shift by the respective $1 to a new supply curve entitled Stax.

With the new supply curve, the quantity (the point where the demand curve meets the new supply curve) will now be Qt, with the new price being formed at Pc. However, the producers will not be receiving Pp, because of the tax they have to pay. The economic incidence is thus split between the consumers and the producers. With all these points established, the DWL can be calculated and shown on the graph as a black-filled triangle.

The DWL looks at the total number of units that could be sold if the transactions had been mutually beneficial for both consumers and producers, which they are not because of the taxation that was introduced and because of the economic incidence. The triangle formed between the old supply curve, the old demand curve and Qt and Q* is the DWL. The DWL could actually be calculated as the area of this triangle, according to the formula A = 1/2*h*b (where h and b are the height and base).

The height is P*-Pp and the basis is Q*-Qt. The deadweight.