Question

5. The federal government recently decided to raise the excise tax on hard liquor. 10 pts a. Graphically illustrate the effects of this tax on the market for hard liquor. b. Would a $1 increase in the excise tax on liquor increase the equilibrium price of liquor by $1? Explain. c. How would the excise tax on hard liquor affect a beer distributor?

Answer 1

(a) Consider that the hard liquor market equilibrium initially happens to be at point E, where demand curve (D) intersects the supply curve (S). Hence, the initial equilibrium price and quantity are respectively P₀ and Q₀. If federal government decided to raise the excise tax on hard liquor, the supply curve shifts up from S to S' as shown in the figure below. As a result of which price will be higher and quantity will be lower at the new equilibrium point E₁.

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(b) It actually depends on the elasticity of the demand and supply curve. If distributor is able to pass on the entire tax to the customers, then the increase in price will be $1 for a $1 increase in the excise tax. This happens when the demand curve is perfectly inelastic or the supply curve is perfectly elastic. Otherwise, a part of the tax is passed on to the customer in the form of increase in price and rest is borne by the distributor.

(c) As per the market structure shown here, the demand curve is not perfectly inelastic or the supply is not perfectly elastic. Hence, a part of the tax is passed on to the customer in the form of increase in price and rest is borne by the distributor. As shown in the figure below, the increase in price is less than the increase in tax by the government. As mentioned earlier, the quantity bought and sold will also be reduced as a result of increase in excise tax.