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.