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Difficulty: HardIncidence and Effects of Taxation

A government levies a specific unit tax of ₦120₦120 on a manufactured product. Given that the coefficient of price elasticity of demand (EdE_d) is 2.52.5 and the coefficient of price elasticity of supply (EsE_s) is 0.50.5, which of the following statements correctly evaluates the distribution of the tax incidence between consumers and producers?

  1. Producers bear ₦100₦100 of the tax burden per unit while consumers bear ₦20₦20, because demand is significantly more price elastic than supply.Answer
  2. B
    Consumers bear ₦100₦100 of the tax burden per unit while producers bear ₦20₦20, because high demand elasticity forces buyers to absorb price increases.
  3. C
    Consumers and producers share the tax burden equally at ₦60₦60 per unit, because tax incidence is always divided evenly at market equilibrium.
  4. D
    Consumers bear the entire ₦120₦120 tax burden per unit, because all indirect taxes are automatically shifted forward to the final consumer.

Answer

Producers bear ₦100 of the tax burden per unit while consumers bear ₦20, because demand is significantly more price elastic than supply.
Effective tax incidence is determined by the relative elasticities of demand and supply. The burden falls more heavily on the less elastic side of the market. Here, supply is relatively inelastic (Es=0.5E_s = 0.5) compared to demand (Ed=2.5E_d = 2.5). Using the incidence proportion formulas, consumers bear EsEd+Es=0.53.0=16\frac{E_s}{E_d + E_s} = \frac{0.5}{3.0} = \frac{1}{6} of the ₦120₦120 tax (₦20₦20), while producers absorb the remaining ₦100₦100.

Step-by-Step Solution

1
Identify the relative elasticities of demand and supply
Ed=2.5E_d = 2.5 and Es=0.5E_s = 0.5. Since Ed>EsE_d > E_s, demand is relatively elastic compared to supply.
Tax incidence depends inversely on relative price elasticity. The market side that is less elastic (more rigid) bears a larger share of the tax.
2
Calculate the proportion of the tax passed onto consumers
Consumer Share Ratio=EsEd+Es=0.52.5+0.5=0.53.0=16\text{Consumer Share Ratio} = \frac{E_s}{E_d + E_s} = \frac{0.5}{2.5 + 0.5} = \frac{0.5}{3.0} = \frac{1}{6}.
The formal incidence equation determines the fraction of a specific tax absorbed by buyers.
3
Compute the monetary tax burden for consumers and producers
Consumer Burden=16×₦120=₦20\text{Consumer Burden} = \frac{1}{6} \times ₦120 = ₦20. Producer Burden=₦120−₦20=₦100\text{Producer Burden} = ₦120 - ₦20 = ₦100.
Producers absorb ₦100₦100 (or 56\frac{5}{6}) of the unit tax because consumers will drastically cut back quantity demanded if price rises significantly.

Key Concept

Tax Incidence and Price Elasticities of Demand and Supply
Estimated Time:2m 0s
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Topics

Incidence and Effects of Taxation

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