Examkin

Question

Difficulty: MediumIncidence and Effects of Taxation

When a government levies an indirect tax on a commodity, the entire tax burden is shifted forward to the consumer under which of the following market conditions?

  1. The price elasticity of demand for the commodity is perfectly inelastic.Answer
  2. B
    The price elasticity of demand for the commodity is perfectly elastic.
  3. C
    The price elasticity of supply for the commodity is perfectly inelastic.
  4. D
    The price elasticity of demand is equal to the price elasticity of supply.

Answer

The entire tax burden falls on the consumer when the price elasticity of demand for the commodity is perfectly inelastic (Ed=0E_d = 0).
Tax incidence refers to the ultimate distribution of a tax burden. When demand for a commodity is perfectly inelastic (Ed=0E_d = 0), buyers are completely unresponsive to price changes. Producers can raise the market price by the full amount of the tax without losing sales volume, thereby shifting the entire tax incidence forward onto consumers.

Step-by-Step Solution

1
Define the relationship between tax incidence and elasticity
The proportion of an indirect tax borne by consumers versus producers depends inversely on their relative price elasticities.
The less elastic side of the market has fewer alternatives and absorbs a larger portion of the tax burden.
2
Evaluate the condition for complete forward shifting to consumers
Forward tax shifting occurs when market price rises by the full tax amount (P1=P0+tP_1 = P_0 + t).
This requires consumers to be completely insensitive to price changes, meaning quantity demanded does not drop despite the higher price.
3
Identify the corresponding elasticity value
A vertical demand curve where Ed=0E_d = 0 (perfectly inelastic demand) allows sellers to shift 100% of the tax burden forward to buyers.
When Ed=0E_d = 0, the consumer share formula EsEd+Es=Es0+Es=1\frac{E_s}{E_d + E_s} = \frac{E_s}{0 + E_s} = 1 (or 100%).

Key Concept

Tax Incidence and Price Elasticity of Demand
Rate this question

Topics

Incidence and Effects of Taxation

More questions from this topic