Question

1.. In a perfectly competitive market without interventions, P ∗ = $10. The government then implements a $1 tax. In each of the following cases, what are Pb and Ps (assuming there are still transactions after the tax)?

(a) Demand is elastic, supply is perfectly inelastic.

(b) Demand is inelastic, supply is perfectly inelastic.

(c) Demand is elastic, supply is perfectly (infinitely) elastic.

(d) Demand is inelastic, supply is perfectly (infinitely) elastic.

(e) Both elasticity of demand and elasticity of supply equal 3.  

Answer 1

Assuming that the market price is 10 and tax=1 is imposed, there is now a wedge between what the buyers pay and what the sellers receive.

a)

Demand is elastic, supply is perfectly inelastic-

Since supply is perfectly inelastic, the burden of the tax would fall completely on the producers. This is because the perfectly inelastic supply would mean that the change in quantity would remain zero irrespective of the change in price whereas demand is elastic and the burden on consumers would fall less.

Therefore, in this case Ps=9 and Pb=10 where Ps is the price received by sellers and Pb is the price paid by buyers.

b)

Demand is inelastic, supply is perfectly inelastic-

Since supply is perfectly inelastic, the burden of the tax would fall completely on the producers. This is because the perfectly inelastic supply would mean that the change in quantity would remain zero irrespective of the change in price whereas demand is inelastic and the burden on consumers would fall less.

Therefore, in this case Ps=9 and Pb=10 where Ps is the price received by sellers and Pb is the price paid by buyers.

c)

Demand is elastic, supply is perfectly elastic-

Since supply is perfectly elastic, the burden of the tax would fall completely on the buyers. This is because the perfectly elastic supply would mean that producers are willing to sell any quantity at a fixed price, therefore the consumers will have to adjust to the taxes and would fall prey to the entire burden.

Therefore, in this case Ps=10 and Pb=11 where Ps is the price received by sellers and Pb is the price paid by buyers.

d) Demand is inelastic, supply is perfectly elastic.-

Since supply is perfectly elastic, the burden of the tax would fall completely on the buyers. This is because the perfectly elastic supply would mean that producers are willing to sell any quantity at a fixed price, therefore the consumers will have to adjust to the taxes and would fall prey to the entire burden.

Therefore, in this case Ps=10 and Pb=11 where Ps is the price received by sellers and Pb is the price paid by buyers.

e) Both elasticity of demand and elasticity of supply equal 3-

Given that both the elasticity of supply and elasticity of demand is equal to 3. In such a case when they have identical elasticities the burden of the tax falls equally on both the buyers and the sellers.

Therefore, in this case Ps=9.5 and Pb=10.5 where Ps is the price received by sellers and Pb is the price paid by buyers.