Tax wedge

The tax wedge is the deviation from the equilibrium price and quantity (${\displaystyle P^{*}}$ and ${\displaystyle Q^{*}}$, respectively) as a result of the taxation of a good. Because of the tax, consumers pay more for the good (${\displaystyle P_{c}}$) than they did before the tax, and suppliers receive less for the good (${\displaystyle P_{s}}$) than they did before the tax . Put differently, the tax wedge is the difference between the price consumers pay and the value producers receive (net of tax) from a transaction. The tax effectively drives a "wedge" between the price consumers pay and the price producers receive for a product.

Following the law of supply and demand, as the price to consumers increases, and the price received by suppliers decreases, the quantity that each wishes to trade will decrease. After a tax is introduced, a new equilibrium is reached, where consumers pay more ${\displaystyle (P^{*}\rightarrow P_{c})}$, suppliers receive less ${\displaystyle (P^{*}\rightarrow P_{s})}$, and the quantity exchanged falls ${\displaystyle (Q^{*}\rightarrow Q_{t})}$. The difference between ${\displaystyle P_{c}}$ and ${\displaystyle P_{s}}$ will be equivalent to the size of the per-unit tax.