Education.com
Try
Brainzy
Try
Plus

Microeconomic Policy and Applications of Elasticity Review for AP Economics (page 2)

based on 4 ratings
By McGraw-Hill Professional
Updated on Mar 2, 2011

The Role the Supply Curve Plays in the Impact of an Excise Tax

We have seen that the greater the price elasticity of demand, the smaller the portion of the tax paid by consumers. It is also true that the price elasticity of supply plays a role in determining how much a tax will cause the price to increase and therefore helps to determine which group, consumers or producers, pay a higher burden of a tax.

It again helps to see if we look at two extremes: a perfectly elastic supply curve and a perfectly inelastic supply curve.

A perfectly elastic, or horizontal, supply curve tells us that even a very small change in the price will cause an infinitely large change in the quantity supplied. A per unit tax T imposed on suppliers causes this horizontal supply curve to shift upward by the amount of the tax. In Figure 7.10, you can see that the new equilibrium price is exactly T higher than the old price P0 so consumers pay the entire burden of the tax. The equilibrium quantity decreases from Q0 to Q1 and the government collects tax revenue equal to T*Q1.

A perfectly inelastic, or vertical, supply curve illustrates the special case where any change in the price creates absolutely no change in quantity supplied. Figure 7.11 shows that in this case, the supply curve cannot vertically shift. At the equilibrium quantity Q0, suppliers would like to charge a higher price than P0, but any price above P0 creates a surplus, and this surplus will clear only at the equilibrium price P0. Therefore the firms must pay T to the government for each of the Q0 units that are sold and consumers continue to pay the original price of P0. In this special case, producers pay the entire burden of the tax because, after paying the tax, they receive only (P0 – T) on each unit. The government collects total revenue equal to T*Q0.

Table 7.4 summarizes the effects of a higher excise tax and how these depend upon the price elasticity of supply.

By now you are probably wondering: "How can I keep all of this straight?" If we consider the extreme cases of perfectly elastic and perfectly inelastic demand and supply curves, we can draw some general conclusions.

• As the price elasticity of demand falls, and the price elasticity of supply rises, the greater the consumer's share of a per unit excise tax. Why? Because this describes a situation where the consumer response to a higher price is negligible and the producer's response is sizeable. The group that has the best ability to respond to the higher post-tax price is going to make out better.
• Conversely, as the price elasticity of demand rises, and the price elasticity of supply falls, the greater the producer's share of a per unit excise tax.

Loss to Society

There is also a cost to society when an excise tax is imposed on a competitive market. In the hypothetical soda market depicted in Figure 7.12, the equilibrium quantity is 100 and the equilibrium price is \$1. At this point, the marginal benefit to society exactly equals the marginal cost and net benefit; total welfare (combined consumer and producer surplus) is the greatest. When a \$l excise tax is imposed, the price of sodas increases to \$1.80 and the amount of sodas consumed decreases to 80. The government collects \$80 = \$1 * 80 in tax revenue. With the tax, consumers and producers demand and supply 20 fewer units than without the tax. For these 20 units that go unproduced, the marginal benefit to consumers exceeds the marginal costs to producers. The fact that these 20 units go unproduced and unconsumed results in an inefficient outcome. The triangle labeled DWL used to be earned by society in the form of consumer and producer surplus. With the excise tax, society loses this area; it goes to no one. Economists call this area dead weight loss (DWL) or the net benefit sacrificed by society when such a per unit tax is imposed. Since the key to dead weight loss is a large decrease in quantity below the untaxed outcome, the area of dead weight loss to society increases as the demand or supply curves get more elastic.

Note: Taxes such as these are not the only sources of distortions away from market efficiency. For example, production often generates pollution (a negative externality), which creates a situation where harmful spillover costs are incurred by third parties. Left unregulated, these costs are not captured by the market price and the market will not produce the "correct" amount of a good. These sources of inefficiency, or market failures, are addressed in Chapter 11.

• Taxes create lost efficiency by moving away from the equilibrium market quantity where MB = MC to society.
• The area of dead weight loss (triangle DWL) increases as the quantity moves further from the competitive market equilibrium quantity.

150 Characters allowed

Related Questions

Q:

See More Questions
Top Worksheet Slideshows