Question

Suppose the government were considering increasing the federal tax on gasoline by 50 cents per gallon. in the course of hearings on the proposed legislation, a consumer advocate argued that the tax would simply be another burden on consumers, for gasoline producers would merely pass the tax on to consumers in the form of higher prices. Using your knowledge of Economics, analyze the consumer advocate's argument. in particular, use graphs to show the effect that this type of tax would have on consumers and producers. Also, what are some crucial factors that would cause wither consumers or producers to bear the burden of the tax? In answering the question, assume that gasoline is sold under competitive conditions.

Answer 1

The gasoline tax will decrease the effective price received by sellers. So they will lower output, decreasing market supply. The supply curve will shift leftward, which will increase the price paid by buyers, decrease the price received by sellers and decrease the quantity sold. Consumer surplus (CS) will decrease and producer surplus (PS) will decrease. A deadweight loss will arise.

The tax burden will depend on elasticity of demand and of supply. The more elastic (inelastic) the demand, the lower (higher) the tax burden on buyers and the higher (lower) the tax burden on sellers. Similarly, the more elastic (inelastic) the supply, the lower (higher) the tax burden on sellers and the higher (lower) the tax burden on buyers.

In following graph, D0 and S0 are initial demand and supply curves intersecting at point E with price P0 and quantity Q0.

CS = area AEP0

PS = area BEP0.

The tax shifts S0 leftward to S1, intersecting D0 at point F with price paid by buyers being higher at P1, price received by sellers being P2 and quantity being lower at Q1 (where P1 - P2 = tax per unit).

New CS = area AFP1

New PS = area BGP2

Tax revenue collected by government = area P1FGP2

Deadweight loss = area EFG.