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. 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)? Explain under what conditions this policy will be the most effective? Under what assumption about the elasticity of demand will tax revenues be the highest? Explain your answer.

Answer 1

The tax on gasoline would discourage its use so the demand shifts down. Compared to the pre-tax equilibrium, the price paid by buyers has risen to P1 and the price received by sellers is P2. The quantity consumed is also reduced.

Tax burden is shared between consumers and producers and the degree of this sharing is determined by the relative demand and supply elasticity. When demand is inelastic buyers bear a greater burden and when the demand is relatively elastic, sellers bear a greater tax burden. This is shown in the graph where P1 is increased more for buyers with inelastic demand in part a) and is increased less for buyers with elastic demand in part b)

This policy is most effective in reducing quantity when demand and supply curves are highly elastic.

Tax revenue will be highest when demand and supply curves are highly inelastic