Mankiw in this chapter reiterates how important the concept of taxation is in economics. While he was discussed the applications of taxation in past chapter, he has not fully explained how taxation can affect the welfare, or economic well-being, or participants in a market. Generally, we learn that a tax on a good reduces economic well-being of all participants in a market, whether they are buyers or sellers. This is because when a tax is imposed, the buyer will always pay more and the seller will always receive less. Furthermore, the reduction in total surplus caused by the tax generally exceeds the revenue raised by the government. The fall in total surplus (consumer surplus, producer surplus, and tax revenue) caused by a tax is called the deadweight loss. Taxes have these because they reduce market activity by raising prices and reducing how much sellers make, meaning they cause the market to shrink. More specifically, taxes cause the market to shrink even farther than the level that maximizes total surplus, i.e. when the market is running the most efficiently. A larger elasticity means a larger deadweight loss. A larger tax also means a larger deadweight loss. When a tax increases, it initially raises tax revenue, but if it gets large enough, it causes tax revenue to shrink.
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