7.2 Microeconomic Policy and Applications of Elasticity
Main Topics:Excise Taxes, The Role the Supply Curve Plays in the Impact of an Excise Tax,
Subsidies, Price Floors, Price Ceilings
Excise Taxes
Government occasionally imposes an excise taxon the production of a good or service.
Because it is a per unit tax on production, the firm responds as if the marginal cost of produc-
ing each unit has risen by the amount of the tax. Graphically this results in a vertical shift in
the supply curve by the amount of the tax. The reasons for this tax are usually twofold: (1) to
increase revenue collected by the government and/or (2) to decrease consumption of a good
that might be harmful to some members of society. For these reasons, tobacco is a good exam-
ple of an excise tax. Can an excise tax on tobacco raise money for government? Can it deter
people from smoking? Let’s use our two extreme demand curves to see where these goals
might, or might not, be achieved and how the price elasticity of demand plays a critical role
on where the burden, or incidence, of the tax rests. Economists commonly express the inci-
dence of the tax as the percentage of the tax paid by consumers, in the form of a higher price.
Demand Is Perfectly Inelastic
If the demand for cigarettes is perfectly inelastic (Ed=0), then the demand curve (D 0 ) is verti-
cal. With an untaxed supply (S 0 ) of cigarettes, the initial price of a pack of cigarettes is P 0 and
Q 0 packs of cigarettes are consumed every day. If a per unit tax of Tis imposed on the produc-
ers of cigarettes, the supply curve shifts upward by T. Be careful! This is not an “increase in
supply”!Because the demand is perfectly inelastic, the equilibrium quantity remains at Q 0 , but
the new price rises to P 0 + T. Total dollars spent on cigarettes increases from P 0 ¥Q 0 to (P 0 + T)
¥Q 0. The revenue collected by the government is equal to the area of the rectangle T¥ Q 0.
Did our excise tax accomplish our goals? Since quantity remained constant, the tax did
nothing to decrease the harmful effects of smoking in society and only increased tax rev-
enues for the government. In fact, because the quantity demanded did not fall, this scenario
creates the largest revenue rectangle collected by the government. Who paid the burden of
the tax? In Figure 7.7, you can see that the entire tax was paid by consumers in the form of
a new price exactly equal to the old price plus the tax.
Demand Is Perfectly Elastic
Figure 7.8 shows that if the demand for cigarettes is perfectly elastic (Ed=°), then the
demand curve (D 0 ) is horizontal. With an untaxed supply (S 0 ) of cigarettes, the initial price
of a pack of cigarettes is P 0 and Q 0 packs of cigarettes are consumed daily. The per unit tax
Elasticity, Microeconomic Policy, and Consumer Theory ‹ 83
Quantity
Price $
SSR
SLR
Q 0 Q 1
P 0
P 1
Figure 7.6
KEY IDEA
