Question

By using the partial equilibrium framework, explain who bears the burden of an ad valorem tax levied on buyers i.e. consumers.

Answer 1

Partial equilibrium model is the clearance on the market of some specific goods is obtained independently from prices and quantities in other markets. Partial equilibrium framework shows the price responses depend largely on demand and supply characteristics. When supply is a more elastic than demand in the long-run is a case of perfect competition, the model predicts nearly complete shifting of taxes to consumer prices. Partial equilibrium frame work implies a number of restrictions on market behavior. Partial equilibrium analysis is useful, reasonably accurate, only when looking at tax which applies only to that group of commodities. An ad valorem tax is based on the assessed value of a property, product, or service, example property taxes on real estate, sales tax on consumer goods and VAT on the value added to the final product or service. An ad valorem tax is a percentage of the price of the commodity, so that the tax collected per unit will fall if the price of the unit falls. Producer prices rise with an increase in an ad valorem tax which is levied on buyers i.e. consumers. Over shifting of an ad valorem tax occurs when the percentage change in the producer price exceeds 100%. Ad valorem taxes have an impact more like taxes in perfectly competitive markets and so should lead to less over shifting than unit taxes. Ad valorem tax consists of sales tax and value added tax (VAT). An ad valorem tax τ on buyers of x makes consumers pay a final price of q = (1 + τ) p, here the firms only receive p so that a total of t = τ p per unit goes to the government.