Question

Government intervention (II) (Question 10):

Suppose that, in the market for soft drinks (in litres),

     demand is given by P = 20 – 0.3Q; and

     supply is given by P = 0.1Q.

In order to raise revenue, the government decides to impose a $0.5 per litre tax on soft drinks. Use these facts to answer the following questions.

    A) On a graph, demonstrate the effect of the tax on the equilibrium price and quantity. (Clearly label the value of each both before and after the tax.)

    B) Show on the graph and calculate the tax revenue and deadweight loss that result from the tax. Briefly explain why a per-unit tax results in a deadweight loss.

    C) Graphically show the incidence of the tax i.e. the consumers and producers burden of the tax.

        i)Who bears the greater burden of the tax, producers or consumers? Explain why this is the case.

        ii)If the elasticity of supply increased, what do you expect to happen to the incidence of the tax? Explain.

    D) Apart from a per-unit tax, what is another measure that the government could impose to reduce the quantity of soft drink consumed? Evaluate whether this is better than a per-unit tax. Is there a measure which will not result in a deadweight loss?

    E) Given that a per unit tax creates deadweight loss and is not Pareto efficient, identify a Pareto improving transaction to eliminate this deadweight loss.

Answer 1

A) Demand is given by P = 20 – 0.3Q; and

     supply is given by P = 0.1Q.

So, Equillibrium Point :

20 - 0.3Q = 0.1 Q

-0.3Q - 0.1Q = -20

-0.4 Q = -20

Q = 50

Equillibrium Price : 0.1 * 50

= 5

By imposing a tax of $0.5 per litre, the buyer pays a higher price and the seller receives the lower price. This reduces the demand, shifting the buyer's equillibrium price to a higher price at lower quantities. As seller receives a lower price, less supply would be there shifting the seller's equillibrium down to a lower price and quantity.

B) As the buyer pays a higher price and the seller receives the lower price, so it results in deadweight loss. This is because seller would supply less and buyer's demand would reduce and thus the overall benefit for the economy reduces. This results in deadweight loss.

Tax Revenue = Tax * Quantity

C) Consumers will bear the tax burden more as they need topay more than the previous price.

If the elasticity of supply increased, due to decrease in price, the supply would reduce in much larger quantity and thus the suppliers would bear the tax burden more.

D) Apart from per-unit tax, the government can put a restriction on the advertisement telecasted of soft drinks.If tehre would be no advertisement telecasted about soft drinks,people will not be aware of the soft drinks and thus the consumption reduces automatically. There would be no deadweight loss in such case.