Question

On a graph, show the effect of a per unit tax on SELLERS of cigarettes. (This requires you to think about the shape of the demand curve for cigarettes. You can assume a sort of neutral supply curve. Indicate the change in price and quantity from the tax. The consumer and producer surplus after the tax, the tax incidence on buyers and sellers and the deadweight losss. Who pays more of this tax?

Thank you!!

Answer 1

In the market for cigarettes, demand is inelastic, while supply is assumed to be unitary elastic.

Due to this, the burden of the tax will fall more upon the buyers.

Since the tax is initially levied on sellers, it will shift the supply curve to the left.

After the shift, the price that buyers pay will rise, the price that sellers receive will fall, and the quantity consumed will fall.

Consumer and producer surplus will both fall.

The extent to which total surplus will fall, will determine the deadweight loss.

In the given diagram, a tax of size t is represented by the red vertical line, placed as a wedge between supply and demand.

The tax causes quantity to decrease from Q to Q_t

The price that buyers pay rises from P to P_b

The price that sellers receive falls to P_s

The incidence on buyers is P_b minus P

The incidence on sellers is P minus P_s  

It can be seen that the incidence on buyers is greater than the incidence on sellers, as demand is inelastic

Consumer and producer surplus both fall due to the tax.

CS is the area above P_b and below the demand curve.

PS is the area below P_s and above the supply curve.

The pink shaded triangle is the deadweight loss.

The government collects revenue equal to (t x Q_t) -- tax size times quantity taxed