When the government decides to impose a tax on sellers of a good or se

When the government decides to impose a tax on sellers of a good or service, sellers try to pass the tax on to consumers by raising the price of the good being sold.

Assume the government decides to place a $1 tax on each unit of a good sold, e.g., tires. Using the simple model of supply and demand, illustrate what would happen to the price and quantity of tires sold. Would the amount of tax paid by the consumer (as opposed to the producer) be greater when demand is elastic or inelastic? Why?

ANSWER

The imposition of the tax would cause the supply curve to shift left as suppliers raise the price of each unit offered by $1 in an effort to pass on the tax to consumers. This would cause the supply of tires to decrease, i.e., the supply curve would shift left, causing equilibrium price to rise and equilibrium quantity to decrease. However, assuming the supply and demand curves for tires have the usual shapes, equilibrium price would rise by something less than $1. The actual increase in the per unit price of tires would depend, all else constant, on the price elasticity of demand. The more inelastic demand is (as illustrated by a steeper demand curve), the greater the increase in price and vice versa.