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Microeconomic Policy and Applications of Elasticity Review for AP Economics

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By — McGraw-Hill Professional
Updated on Mar 2, 2011

Review questions for this study guide can be found at:

Elasticity, Microeconomic Policy, and Consumer Theory Review Questions for AP Economics

Main Topics: Excise Taxes, Government Subsidies, Price Floors, Price Ceilings

Excise Taxes

Government occasionally imposes an excise tax on the production of a good or service. Because it is a per unit tax on production, the firm responds as if the marginal cost of producing each unit has risen by the amount of the tax. Graphically this results in a vertical shift in the supply curve by the amount of the tax. The reasons for this tax are usually twofold: (1) to increase revenue collected by the government and/or (2) to decrease consumption of a good that might be harmful to some members of society. For these reasons, tobacco is a good example of an excise tax. Can an excise tax on tobacco raise money for government? Can it deter people from smoking? Let's use our two extreme demand curves to see where these goals might, or might not, be achieved, and how the price elasticity of demand plays a critical role on where the burden, or incidence, of the tax rests. Economists commonly express the incidence of the tax as the percentage of the tax paid by consumers, in he form of a higher price.

Demand is Perfectly Inelastic

If the demand for cigarettes is perfectly inelastic (Ed = 0) then the demand curve (D0) is vertical. With an untaxed supply (S0) of cigarettes, the initial price of a pack of cigarettes is P0 and Q0 packs of cigarettes are consumed every day. If a per unit tax of T is imposed on the producers of cigarettes, the supply curve shifts upward by T. Be careful! This is not an "increase in supply"! Because the demand is perfectly inelastic, the equilibrium quantity remains at Q0, but the new price rises to P0 +T. Total dollars spent on cigarettes increases from P0 * Q0 to (P0+T) * Q0. The revenue collected by the government is equal to the area of the rectangle T * Q0.

Did our excise tax accomplish our goals? Since quantity remained constant, the tax did nothing to decrease the harmful effects of smoking in society and only increased tax revenues for the government. In fact, because the quantity demanded did not fall, this scenario creates the largest revenue rectangle collected by the government. Who paid the burden of the tax? In Figure 7.7, you can see that the entire tax was paid by consumers in the form of a new price exactly equal to the old price plus the tax.

Demand is Perfectly Elastic

Figure 7.8 shows that if the demand for cigarettes is perfectly elastic (Ed = ∞), then the demand curve (D0) is horizontal. With an untaxed supply (S0) of cigarettes, the initial price of a pack of cigarettes is P0 and Q0 packs of cigarettes are consumed daily. The per unit tax of T shifts the supply curve upward by T, but with a perfectly elastic demand curve, the equilibrium price of cigarettes does not change, while equilibrium quantity demanded falls to Q1. Total spending by consumers falls to the area P0 * Q1. Tax revenue for the government is a much smaller rectangle T * Q1.

Microeconomic Policy and Applications of Elasticity

Who paid for the tax in this case? Because the price of a pack of cigarettes did not increase after the tax, it was not the consumers. Each producer receives a price of P0 but must then pay T to the government so the net price received from each pack of cigarettes is (P0 – T). So the producer pays the entire share of the tax when demand is perfectly elastic. Compared to the perfectly inelastic scenario, the government collected much fewer tax revenue dollars, but the maximum decrease in harmful cigarette consumption is a definite plus.

With these two extreme cases as benchmarks, we can conclude that as demand is more inelastic, consumers pay a higher share of an excise tax. Government revenues from the excise tax increase with inelastic demand, but the goal of decreasing consumption sees only minimal success. Table 7.3 summarizes the effects of a higher excise tax and how these depend upon the price elasticity of demand.

Since cigarette demand is usually inelastic, significant improvements in the health of consumers is probably not the primary outcome of higher excise taxes, although they would seem to be effective revenue generating devices. Ironically, although the tax is actually imposed on suppliers of cigarettes, most of the burden of the tax falls upon consumers. Figure 7.9 illustrates an inelastic demand for cigarettes, before and after an excise tax.

Microeconomic Policy and Applications of Elasticity

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