Question

Consider the market for tobacco where the original demand curve and supply curve intersect at the equilibrium. Explain in words how a tax on tobacco will change the supply curve, equilibrium, price level for consumers and producers, output level and tax revenue and deadweight loss.

Answer 1

Initial Equilibrium occurs at point E where both Demand and Supply curves intersect. Equilibrium quantity and price are Q1 and P1.

Imposition of tax on tobacco makes the cost of producing the tobacco higher. Increasing cost of production will shift the supply curve to left from SS to SS + Tax.

Consumer Surplus before tax = Area of Region AEP1

Consumer Surplus after Tax = Area ABC.

Area AEP1 > Area ABC. So, there is decline in the consumer surplus

Producer Surplus before tax = Area EP1G

Producer Surplus after tax = FDG

Area EPG > Area FDG. So, producer surplus also decline.

Equilibrium price level increases from P1 to B.

Equilibrium quantity decreases from Q1 to Q2.

Tax Revenue before Tax = 0

Tax Revenue after tax = Area of Rectangle BCDF

Deadweight Los due to Tax = Area of triange CDE

So, due to tax, people starts purchasing less quantity due to its higher price. The tax imposes a social loss in the form of deadweight loss.

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