17.1 Graphing Exercise: Tax Incidence

Many goods and services are subject to an excise tax. Such a tax is usually levied on the producers, who properly view it as an increase in their marginal cost. However, it is often incorrect to assert that producers pay the tax, as the tax may be shifted onto consumers in the form of higher prices. The incidence of the tax is a measure of the ultimate resting place of the tax - its relative impact on consumer and producer price, as well as its impact on output - which depends on the elasticities of supply and demand.

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Exploration: How does an excise tax affect equilibrium price and quantity?

The graph illustrates the market for an inexpensive domestic wine, which may become subject to an excise tax. Prior to the tax, the price is $4.00 per bottle and 15 million bottles are sold each month. To use the graph, click anywhere inside the box labeled Excise Tax and enter an amount up to $2.00. The graph illustrates the after-tax price paid by consumers, the amount of total tax revenue collected (and its split between buyers and sellers), and any efficiency loss created by the tax. By dragging the D and S labels you can change the elasticities of demand and supply, respectively. Click Reset to start over.

1. At the initial elasticities of supply and demand shown, what is the incidence of a $1 tax per bottle in this market?
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2. Government revenue analysts observe that prior to a tax on wine, 15 million units are sold each month. They estimate that a $1 excise tax will earn $15 million tax revenue. Will their estimates be correct? Why?
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3. How will an increase in the elasticities of demand or supply affect the government's tax revenue?
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4. How is the incidence of a tax affected by the elasticities of supply and demand?
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5. Is there any combination of supply and demand elasticities that would allow sellers to shift the entire tax burden onto consumers?
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6. Experiment on your own. How is the size of the efficiency loss of the tax affected by the amount of the tax and the elasticities of supply and demand?
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