Tax Incidence and Price Elasticity of Demand and Supply (HL)

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    Tax Incidence and Price Elasticity of Demand and Supply (HL)

    If a good with inelastic demand is taxed, the tax burden can be easily passed on to the consumer (PED is less than PES)

    This means the tax burden on the consumer (C) is greater than the tax burden on the producer (P).

    As shown in this diagram, the producer would like to raise the price to P4, to pass all the tax burden onto consumers. However, this would cause excess supply, so prise falls to a new equilibrium at P2.

    If a good with elastic demand is taxed, the tax burden on the consumer (C) is less than the tax burden on the producer (P). (PED is more+ than PES)

    In this second scenario, the producer would like to increase the price to P4, to pass all the tax burden on to consumers. However, this would cause excess supply, so price falls to a new equilibrium of P2. This is where enough consumers would continue to buy but not all of the tax burden is taken by the producer.

     

    Example:

    Qd = 2,000 – 200P

    Qs = -400 + 400P

    The price when there is no quantity supplied:

    Qs = -400 + 400P

    0 = -400 + 400P

    400 = 400P

    P = 1

    Quantity demanded when the price is zero:

    Qd = 2000 – 200P

    Qd = 2000 – 200(0)

    Qd = 2000

    Qd = 2000 – 200P

    The price when there is no quantity demanded:

    0 = 2000 – 200P

    200P = 2000

    P = 10

    Quantity supplied when the price is zero:

    Qs = -400 + 400P

    Qs = -400 + 400(0)

    Qs = -400

    A specific tax of $1.50 is imposed on the product.

    Original consumer surplus = ((6*12000)/2) =$3600

    New consumer surplus = ((5*1000)/2) =$2500

    Original producer surplus = ((4*12000)/2) =$2400

    New producer surplus = (1.5*1000) + ((2.5*1000)/2) = $2750

    Original community surplus = 3600 + 2400 =$6000

    New community surplus = 2500 + 2750 = $5250

    Equilibrium has shifted from $4 and 1200 units to $5 and 1000 units.

    Original producer revenue = 1200 * 4 = $4800

    New producer revenue = 1000 * 3.5 = $3500

    Original consumer expenditure = 1200 * 4 = $4800

    New consumer expenditure = 5 * 1000 = $5000

    Government revenue = 1000 * 1.50 = $1500

    Producer tax burden = 1000 * 0.50 = $500

    Consumer tax burden = 1000 * 1 = $1000