Using Supply and demand to explore the effects of taxes.

Conventional wisdom indicates that when a tax is placed on an item it is simply passed on to the consumer in the full amount. In some very rare cases it might be. However, it is usually the case that some of the tax is paid by consumers in the form of increased prices, and some of the tax is paid by producers in the form of decreased sales. Understanding how this division works, and how it depends on elasticity, is important to anyone who either pays taxes or votes for politicians who pass tax laws.

Exploration: What determines the distribution of a tax between buyers (who may bear a higher cost) and sellers (who may lose sales)?

Economic Naturalist 7.2 asks what the impact of a $100 tax on automobiles will be in the long run. The conditions of the exercise are that inputs can be obtained in unlimited quantities at fixed market prices and the cost to produce one automobile is $10,000. In this case the supply of cars is infinitely elastic (perfectly flat in P, Q space). The $100 tax simply pushes the cost of producing an automobile up from $10,000 to $10,100 and, for any fixed down-sloping demand curve will simply increase the price of the car by the full $100.

1. Notice that the equilibrium price for cars, in this case, is $10,000. Enter an Excise Tax of $100 in the box above the graph. What happens to the equilibrium price and quantity of cars sold?
   
   
2. What would happen to the price and quantity if the demand for cars were more elastic (more sensitive to changes in price)? Click on the Reset button and then change the Demand to Relatively Elastic by clicking on the Rotate Demand button to make demand flatter, and repeat the exercise of adding in a $100 excise tax.
   
   
3. What would happen under this scenario if the supply, rather than being flat, were upward sloped? That would occur if the original condition that "inputs can be obtained in unlimited quantities at fixed market prices" did not hold. In other words, as more cars are produced the cost per car of producing them rises. Click the Reset button and then adjust the supply curve to "More Elastic" by clicking on the Rotate Supply button.. Now repeat the exercise by adding in a $100 excise tax, as before.
   
   
4. From this starting point, notice the surplus available to be divided up and how the division takes place between the buyers and the sellers. (You may want to return to your book and refresh your memory about consumer and producer surplus.) Now, if we impose a tax on the sellers, say $150 per car, what will be the impact on price, quantity, market surplus and the division between buyers and sellers?
   
   
5. How does the outcome above differ if the supply is not perfectly elastic? Reset the applet, click on the Rotate Supply button so that the supply is "More Elastic" and repeat the exercise above.
   
   
6. Suppose we go to the other extreme, a perfectly inelastic demand. In order to examine this situation, reset the graph and then click on the Rotate Supply once to cause the supply curve to be "more elastic". Then click on the Rotate Demand button until the demand curve is perfectly inelastic. Now repeat the exercise above, except this time make the excise tax be only $100. How does the elasticity of demand affect the distribution of the surplus and the amount of deadweight loss from a tax?

View Answers

Exercise picked up from the 2e Economics textbook.