Question

If the U.S. wants to maximize tax revenues, should we impose an excise tax on McDonalds or gasoline? Why? Make sure to include a graph and the equation for elasticity and your assumptions regarding the elasticity of demand for both products.

Answer 1

Elasticity of demand is calculated as: %change in quantity demanded / %change in price

Inelastic goods are those whose demand does not change by much when price rises because these goods are necessary goods for consumers. On the other hand, elastic goods are those goods whose demand change by much more than the price change as these are considered to be luxury goods.

As gasoline is a necessary good, its demand must be inelastic while demand of McDonalds must be elastic. Government should put tax on inelastic good because consumers will not be able to reduce their quantity consumed and generate more revenue.

In the above figure, tax revenue generated from inelastic good is area of portion A + B while tax revenue of A + B from elastic good at left side is much lesser than A + B of inelastic good on right side.