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Incidence of Indirect Tax on Price Elasticity of Demand

With the use of diagrams, explain how the price elasticity of demand for a product influences the incidence of an indirect tax on that product. [8]

Category:

Elasticity

[CIE A level May 2018]

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Answer

Tip: Do not only show the impact of an indirect tax on price and quantity but make clear reference to how it relates to tax incidence.


Step 1 : Define ‘price elasticity of demand’ , ‘tax incidence’ and ‘indirect tax’ in the introduction.
(Knowledge and understanding)

The government often implement policies such as indirect taxation in order to dissuade the production and consumption of certain goods such as cigarettes. An indirect tax a tax levied on goods and services by the government. Examples of indirect tax include excise tax, VAT, and customs tax. However, the effectiveness of such indirect taxation depends on tax incidence. A tax incidence is the division of a tax burden between buyers and sellers. The incidence of an indirect tax depends on the price elasticity of demand. The price elasticity of demand is a numerical measure of the responsiveness of the quantity demanded for a product following a change in the price of that product.


Step 2 : Explain how the price elasticity of demand influences the incidence of an indirect tax.
(application using a diagram)

The incidence of indirect taxes depends on the price elasticity of demand for the commodity in question. The diagram below shows how the tax incidence changes as price elasticity of demand changes.

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In both diagrams the size of the tax is the same: the supply curve shifts upwards by the same amount. Price rises to P2 in each case and quantity falls to Q2. However, the size of this increase in price and decrease in quantity differs in both cases. This is because of the difference in the price elasticity of demand. The total tax revenue is given by the total shaded area. The blue area is the amount of the tax passed on to consumers and represents the consumers’ share of the tax. The pink area is the amount of the tax passed on to producers and represents the producers’ share of the tax.

➤ 2.1 In Figure 1, the consumer's share of the tax is larger than the producer's share. This is because the price elasticity of demand is inelastic.

If there is a large change in price for an inelastic good, there will be a far lesser change in quantity demanded. For example, commodities, which have become habitual necessities for the consumers have inelastic demand. This is because such a commodity becomes a necessity for the consumer and he continues to purchase it even if it's price rises following the imposition of a tax. Alcohol, tobacco, cigarettes, etc. are some examples of habit-forming commodities.

➤ 2.2 In Figure 2 , the producer's share of the tax is larger than the consumer's share as price elasticity of demand is elastic.

Elastic demand means that a small change in price will result in a relatively larger change in quantity demanded. Goods with many substitutes will have elastic demand. For example, if the price of Pepsi rises because of the imposition of an indirect tax, buyers will be encouraged to switch to an alternative such as Coca Cola.

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Step 3 : Conclude
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To conclude, when price elasticity of demand is elastic the producer's share of the tax is larger than the consumer's share and when price elasticity of demand is inelastic the consumer's share of the tax is larger than the producer's share.

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♕ Guidance
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An indirect tax will shift the supply curve to the left. This will raise the price of the product. The incidence depends upon price elasticity. If the demand is inelastic, the consumer bears most of the incidence. If the demand is elastic most of the incidence falls upon the producer. The candidate is NOT required to define elastic or inelastic. They need to demonstrate that they understand the concepts through their application in answer to the question.

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♕ Marking scheme
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up to 4 marks for knowledge and understanding:
Of the meaning of an indirect tax (1 mark)
For a clear understanding of a price-elastic demand (1 mark)
For a clear understanding of price-inelastic demand (1 mark)
For a clear understanding of the meaning of the incidence of taxation (1 mark)
Up to 4 marks for application using a diagram:
• to show that if a good is price elastic the incidence of an indirect tax will fall mainly on the producer (2 marks)
• and if it is price inelastic the incidence it will fall mainly on the consumer (2 marks)

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♕ Examiner report
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There were some good responses here with many candidates providing a technically sound explanation of the way in which price elasticity influences the incidence of an indirect tax. It is still frustrating however to read explanations of price elasticity and inelasticity that lack precision. When asked to ‘explain’ it is not enough to state that a price inelastic good has a coefficient of less than one or that demand does not change ‘by very much’ when price rises. More accurately it should be explained that in the case of price inelastic goods the percentage change in quantity demanded is less than the percentage change in price. This clear explanation would lead to more accurate application. Similarly some explanations of the incidence of an indirect tax were often equally vague. Disappointingly, some candidates showed the impact of an indirect tax on price and quantity but made no reference whatsoever to tax incidence. Incomplete answers inevitably scored poorly as did those answers that contained long descriptions of every type of price elasticity with no application to the question set.

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