Question

When the government imposes a tax on the sale of a particular good, the sellers try to pass the tax onto consumers by raising the price of the good sold. Assume you own a tire company, and the government decides to impose a $1.00 tax on each tire sold. 1. Based on the basics of supply and demand, explain what would likely happen to the price you charge and the quantity of tires sold. 2. Would the amount of the tax passed onto the consumer be greater when demand is elastic or inelastic? Explain.

Answer 1

(1) The tax will decrease the effective price I receive by $1 at every level of output, therefore I will reduce output. Supply will fall, shifting supply curve leftward, leaving demand unchanged, which will increase price and decrease quantity.

(2) When demand is inelastic (elastic), consumers are less (more) sensitive to an increase in price (caused by tax), therefore producers can pass on a higher (lower) tax burden to the consumers, and bear a lower (bigger) tax burden themselves.