Question

Suppose that the federal government has decided that air pollution produced by gasoline should be reduced. To achieve this objective, the federal government is considering the introduction of an additional tax of 50 cents per litre on gasoline.

1. Using a demand and supply diagram illustrate the effect of such a tax on the price of gasoline. Will the consumers of gasoline or the producers of gasoline bear the highest tax burden (incidence)?
2. Explain under what conditions this policy will be the most effective?
3. Under what assumption about the elasticity of demand will tax revenues be the highest? Explain your answer.

Answer 1

When we impose tax of 50 cents per litre on Gasoline then the supply curve will shift upward or leftward by the amount of tax. In the following diagram we are showing the effect of tax and it creates impact on price and quantity and how tax burden comes to consumer and producer.In the above figure we measured quantity of gasoline in horizontal axis and price of gasoline in vertical axis. The initial equilibrium took place at point E1. Corresponding to E1, quantity is Q1 and price is P1. Now we have imposed tax of 50 cents and as a result supply curve shifted leftward and vertical distance between two supply curve shows tax is 50 cents. New equilibrium took place at point E2. Corresponding to E2 , quantity is Q2 and price is P2. Here demand curve is more elastic than the supply curve. It shows that supply curve is relatively inelastic and demand curve is relatively elastic. Now the tax amount is P2P3 which is equal to 50 cents. Out of P2P3, consumer pays P1P2 and producer pays P1P3. So tax burden on consumer is P1P2 and tax burden on producer is P1P3. Here producer pays the highest tax. So whose elasticity will be that particular party will pay more tax. So inelastic leads to more tax burden and elastic leads to less tax burden. Which suppliers have more elastic than consumers then consumer will pay more tax.

b. The policy will be most effective means the tax revenue collection will be highest when demand is comparatively inelastic and supply is comparatively elastic. If demand is fully inelastic and supply is fully elastic tax revenue will be highest.

C) If demand elasticity is completely inelastic the tax revenue will be highest. Because there will be no change in quantity though the price changes by the tax amount.