Question

Widgets are and always have been subject to a price ceiling. Everyone’s time is worth $4 per hour, and the line to buy a widget is two hours long. One day the government imposes a $10 sales tax on widgets (while keeping the price ceiling in place). a) Illustrate the gains and losses to all relevant groups. b) Can you determine whether the sales tax causes an increase or a decrease in social gain? If so, explain how you know. If not, which areas on your graph would you have to measure to determine the answer?

Answer 1

A price ceiling is a legal maximum on the price at which a good can be sold. Example of price ceiling include price ceilings on water during drought. A price ceiling leads to a shortage, if the ceiling is binding, because suppliers won’t produce enough goods to meet demand unless the price is allowed to rise above the ceiling.

• Taking the case of No Tax: The demand curve is D1 and the supply curve is S as shown in Fig: 1. The equilibrium price is P₁ and the equilibrium quantity is Q₁.

• If the tax is imposed on Widget buyers, the demand curve shifts down by the amount of the tax ($10) to D₂. The downward shift in the demand curve leads to a decline in the equilibrium price to P₂ (the amount received by sellers from buyers) and a decline in the equilibrium quantity to Q₂. The price received by sellers declines by P₁ – P₂, shown in the Fig: 1 as P_S. Buyers pay a total of P₂ + $10, an increase in what they pay of P₂ + $10 - P₁, shown in the Fig: 1 as P_B.

Fig: 1

• If the tax is imposed on Widget sellers, as shown in Fig: 2, the supply curve shifts up by the amount of the tax ($10) to S₂. The upward shift in the supply curve leads to a rise in the equilibrium price to P₂ (the amount received by sellers from buyers) and a decline in the equilibrium quantity to Q₂. The price paid by buyers declines by P₁ - P₂, shown in the Fig: 2 as P_B. Sellers receive P₂ and pay taxes of $10, receiving on net P₂ - $10, a dcrease in what they receive by P₁ - (P₂ - $10), shown in the Fig: 2 as P_S.

  

Fig: 2