Question

Under what conditions would it be possible for an excise tax to have no efficiency cost and, in fact increase economic efficiency? Show this graphically. Support your answer with an example of something that has a perfectly inelastic supply or nearly perfectly inelastic supply.

Answer 1

There is no efficiency cost or deadweight loss when demand curve is perfectly inelastic with supply curve upward sloping or supply curve is perfectly inelastic with demand curve downward sloping. Fully inelastic side of the market bears all of the tax which cause no deadweight loss.

In the graph below, perfectly inelastic supply curve (vertical axis) will cause all tax to fall on sellers. Initailly the equilibrium price is Pe. After tax, the price received by sellers falls to Ps. Thus, we can say that there is no tax burden on consumers and (Pe - Ps) burden on producers.

When supply is nearly inelastic and tax is imposed. It will raise price for consumer to Pc and reduce price received by sellers to Ps with reduction in quantity traded to Qt. It cause deadweight loss in the society equal to sum of portion A + B.