Question

1. Discuss the effects of the tax on suppliers related to the following subjects:
   1. Change in resulting price and quantity.
   2. Revenue generated by the tax.
   3. Effect on consumer surplus compared to consumer surplus without the tax.
   4. Effect on producer surplus compared to producer surplus without the tax.
   5. Who pays more of the tax, consumer or producer and why?
   6. What is the effect of the tax on overall economic efficiency?

Answer 1

We discuss the effect of tax on suppliers using following graph.

Pre-tax equilibrium is at point E where demand curve (D0) intersects pre-tax supply curve (S0) with initial price p* and quantity q*.

(a) After the tax, effective price received by sellers fall,s so firms lower supply. The supply curve shifts leftward to S1. After-tax equilibrium is at point F where demand curve (D0) intersects after-tax supply curve (S1) with price paid by buyers being p1,. price received by sellers being p2 and lower quantity q1. Market price being p1, after-tax price is higher and after-tax quantity is lower.

(b) Unit tax being equal to (p1 - p2), tax revenue is area p1FGp2.

(c) Consumer surplus (CS) = Area between demand curve and price.

CS before tax = Area AEp*

CS after tax = Area AFp1

Loss in CS = Area p*EFp1

(d) Producer surplus = Area between supply curve and price.

PS before tax = Area BEp*

PS after tax = Area BGp2

Loss in PS = Area p*EGp2

(e) Tax incidence on buyer and seller depends on elasticity of demand curve and elasticity of supply curve. When demand is more elastic than supply, sellers bear higher tax incidence and when supply is more elastic than demand, buyers bear higher tax incidence. In the graph,

Tax incidence of buyers = After-tax price paid - Pre-tax price = p1 - p*

Tax incidence of sellers = Pre-tax price - After-tax price received = p* - p2

(f) Tax leads to a loss in economic efficiency equal to area EFG.