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

(a)

In following graph, D0 and S0 are pre-tax demand and supply curves intersecting at point A with price P0 and quantity Q0. The tax will lower the effective price received by sellers, so they will lower production. Market supply will fall, shifting supply curve leftward to S1 which intersects D0 at point B. Price paid by buyers rises to P1, price received by sellers falls to P2 and quantity falls to Q1. Unit tax equals (P1 - P2).

Unless demand and supply curves are perfectly elastic or inelastic, for a downward-sloping demand curve and upward-rising supply curve, both consumers and producers will share the tax burden.

(b)

Objective of the tax is to decrease quantity traded. Therefore, when demand is perfectly elastic and demand curve is horizontal, the tax policy will be most effective since decrease in quantity from taxation will be highest.

(c)

The more inelastic the demand, the higher the tax revenue and the more inelastic the supply, the higher the tax revenue. Therefore tax revenue will be highest when demand is perfectly inelastic or supply is perfectly inelastic.