Elasticity and tax incidence
Context for Use
The point of this AE is get students to understand how the relative price elasticities of supply and demand are what really determine who bears the burden of an excise tax. They are presented with a scenario where the government places a tax on cigarettes and they are asked who would oppose it the most (buyers or sellers). They should discuss which is likely to have a higher price elasticity - supply or demand for cigarettes - as part of their answer to this question.
Expected Student Learning Outcomes
- Explain how the relative magnitudes of the price elasticity of demand and supply determine the incidence of an excise tax.
Information Given to Students
Cigarettes are proven to lead to serious negative health effects for both smokers and those exposed to the second-hand smoke. In an effort to reduce smoking, the government requires the suppliers of cigarettes to pay a per-unit tax on each pack of cigarettes sold. Who would be most against this tax policy? Note that the degree of opposition to the tax corresponds exactly to the increase in price paid by the buyers or the price received by the sellers for cigarettes, so you should consider how the tax changes those prices when selecting your answer.
A. Cigarette manufacturers will be more opposed to this tax.
B. Cigarette smokers will be more opposed to this tax.
C. Both cigarette manufacturers and smokers will be equally opposed to this tax.
Be prepared to illustrate on a standard supply and demand graph why your answer is correct. Be sure to show how the incidence of the tax is shared between buyers and sellers of cigarettes.
Teaching Notes and Tips
The intent of this question is for the answer to really be "it depends" and for students to understand that what it really depends on is the relative price elasticities of demand and supply. Perhaps answer B is the most likely outcome if students also recognize that the price elasticity of demand is likely higher than the price elasticity of supply in the cigarette market.
Debriefing notes, including discussion questions:
To get students to really understand how relative price elasticities of demand and supply are really what determines the incidence of a tax, you could ask students for examples of other goods which the government might place an excise tax on which would have a different outcome. You might also discuss how the elasticities impact the size of the tax revenue collected by the government as well as the amount of deadweight loss resulting from the excise tax.
Students should understand the incidence of tax depends on the relative elasticities of supply and demand, and not on whom the tax is initially placed.