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 $1 tax imposed on units sold will lower the effective price received by the sellers by $1 for every unit of output, therefore sellers will decrease production. Supply will decrease, shifting supply curve toward left but demand will stay the same, therefore price will increase and quantity will decrease.

(2) With inelastic (elastic) demand, buyers are less (more) responsive to a given rise in price (as a result of the tax), so the sellers can shift a higher (lower) tax incidence to the buyers.