Chapter 6

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FT2. Junk food has been criticized for being unhealthy and too cheap, enticing
the poor to adopt unhealthy lifestyles. Suppose that the state of Oklakansas
imposes a tax on junk food.

a. What needs to be true for the tax to actually deter people from eating junk
food: Should junk food demand be elastic or should it be inelastic?

A: Demand should be elastic, which means sensitive to price.

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b. If the Oklakansas government wants to strongly discourage people from
eating junk food, when will it need to set a higher tax rate: When junk food
demand is elastic or when it is inelastic?

A: The government will need to set a higher tax rate when consumers have
inelastic junk food demand: Only an extremely high price will discourage
these stubborn consumers.

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c. But hold on a moment: The supply side matters as well. If junk food
supply is highly elastic—perhaps because it’s not that hard to start selling
salads with low fat dressing instead of mayonnaise- and cheese-laden
burgers—does that mean that a junk food tax will have a bigger effect than
if supply were inelastic? Or is it the other way around?

A: Elastic supply is better from the government’s point of view, just as

elastic demand is better. As long as the goal is getting the quantity to move
a lot, you want elasticity.

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d. Let’s combine these stories now: If a government is hoping that a small tax
can actually discourage a lot of junk food purchases, it should hope for:

I. Elastic supply and inelastic demand

I. Elastic supply and elastic demand
III. Inelastic supply and elastic demand
IV. Inelastic supply and inelastic demand

A: II: Both should be elastic.

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3. As we saw in the chapter, a lot turns on elasticity. Decades ago, Washington,
DC, a fairly small city, wanted to raise more revenue by increasing the gas tax.
Washington, DC, shares borders with Maryland and Virginia, and it’s very easy
to cross the borders between these states without even really noticing: The
suburbs just blend together.

a. How elastic is the demand for gasoline sold at stations within Washington, DC? In
other words, if the price of gas in DC, rises, but the price in Maryland and
Virginia stays the same, will gasoline sales at DC, stations fall a little, or will they
fall a lot?

A: Washington, DC, gas sales are very elastic: It’s easy to drive across the border
to buy gas where it’s cheapest.

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b. So, when Washington, DC, increased its gasoline tax, how much revenue did it raise:
Did it raise a little bit of revenue, or did it raise a lot of revenue?

A: Gasoline sales in Washington, DC, plummeted and the tax raised very little revenue.

c. How would your answer to b change if DC, Maryland, and Virginia all agreed to
raise their gas tax simultaneously? These states have heavily populated borders with
each other, but they don’t have any heavily populated borders with other states.

A: If they all raised the gas tax simultaneously, they could raise a lot of revenue. The
demand within these three states is more inelastic, since drivers don’t have many
good alternatives to filling up within the tri-state area.

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FT4. In Figure 6.5, what is the total revenue raised by the tax, in dollars? What
is the deadweight loss from the tax, in dollars?

A:
Tax revenue=
500 X $1 = $500.

Deadweight loss =
$1 tax X 200 apples X ½ = $100.

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6. Suppose that Maria is willing to pay $40 for a haircut, and her stylist Juan is
willing to accept as little as $25 for a haircut.

a. What possible prices for the haircut would be beneficial to both Maria and
Juan? How much total surplus (i.e., the sum of consumer and producer
surplus) would be generated by this haircut?

A: Any price greater than $25 will make Juan better off; any price lower than
$40 will make Maria better off. No matter what the price is, the sum of
consumer and producer surplus (the total gains from trade) will be $15.

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b. If the state where Maria and Juan live instituted a tax on services that included
a $5 per haircut tax on stylists and barbers, what happens to the range of haircut
prices that benefit both Maria and Juan? Will the haircut still happen? Will this
tax alter the total economic benefit of this haircut?

A: If Juan has to pay a $5 tax for every haircut he gives, then his willingness to
accept price will rise to $30. At a price of $30, he will give $5 to the government
and have $25 leftover for himself, which was originally the minimum he was
willing to accept. Now Juan and Maria must find a price greater than $30 but less
than $40. There are a lot of prices in between these numbers, so it is still likely
that the haircut would take place. The tax will not necessarily alter the total
economic benefit of the haircut. While the benefit to Maria and Juan will sum
only to $10, the government also receives $5 in tax revenue, so the total
economic benefit generated by the haircut is still $15.
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c. What if instead the tax was $20?

A: If the tax was $20, Juan’s minimum willingness to accept rises to $25 +
$20 = $45. Now, there are no prices high enough to satisfy Juan (higher than
$45) but low enough to satisfy Maria (lower than $40). Therefore, the
haircut will not take place. It will, therefore, not generate any tax revenue.
The total economic benefit will be reduced to $0.

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PS1. Some people with diabetes absolutely need to take insulin on a regular basis to survive.
Pharmaceutical companies that make insulin could find a lot of other ways to make some
money.

a. If the U.S. government imposes a tax on insulin producers of $10 per cubic centimeter of
insulin, payable every month to the U.S. Treasury, who will bear most of the burden of the tax:
Insulin producers, people with diabetes, or can’t you tell with the information given?

b. Suppose instead that because of government corruption, the insulin manufacturers convince
the U.S. government to pay the insulin makers $10 per cubic centimeter of insulin, payable every
month from the U.S. Treasury. Who will get most of the benefit of this subsidy: Insulin
producers, people with diabetes, or can’t you tell with the information given?

A: In both cases, it’s the diabetes patients who are affected: Inelastic buyers face a steep price
hike under a tax and so bear the burden of the tax, and inelastic buyers reap the benefits of the
insulin subsidy.

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PS2. Let’s see if we can formulate any real laws about the economics of taxation.
Which of the following must be true, as long as supply and demand curves have
their normal shape (i.e., they aren’t perfectly vertical or horizontal, and demand
curves have a negative slope while supply curves have a positive slope)?

If there is a tax:
a. The equilibrium quantity must fall, and the price that buyers pay must rise.
b. The equilibrium quantity must rise, and the price that sellers pay must rise.
c. The equilibrium quantity must fall, and the price that sellers receive must fall.
d. The equilibrium quantity must rise, and the price that buyers receive must fall.

A: Both a and c are correct: Quantity falls, the price received by suppliers falls, and
the price paid by the buyer rises.

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PS3. Using the following diagram, use the wedge shortcut to answer these questions:
a. If a tax of $2 were imposed, what price would buyers pay and what price would
suppliers receive? How much revenue would be raised by the tax? How much
deadweight loss would be created by the tax?

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b. If a subsidy of $5 were imposed, what price would buyers pay and what price
would suppliers receive? How much would the subsidy cost the government?
How much deadweight loss would be created by the subsidy?

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PS4. When governments are trying to raise tax revenue, they sometimes attempt to target higher-income
people, since they are in a better position to bear the burden of a tax. However, it can be very difficult to earn
tax revenue from wealthy people.

a. Consider the progressive nature of the U.S. federal income tax system: It’s designed so that higher incomes
are taxed at higher tax rates. Thinking about the elasticity of labor supply, why might it be more difficult to
collect tax revenue from a wealthy individual than from a poor person, all else equal?

A: We might expect the wealthy to have more elastic labor supply. One reason might be related to mobility:
A wealthy person may have the resources necessary to move in order to find a better job, while a poorer
person may not. Likewise, a poorer person cannot take time out of the labor market to wait for a better
opportunity, but a wealthy person can. If a wealthy person has greater labor supply elasticity, then this means
he or she is in a better position to escape the impact of an income tax. Likewise, the total compensation of
higher-paying jobs generally involves more components than just a wage or salary, like benefits, vacation
days, comfortable and clean working environments, etc. So, if a person at a higher-paying job faces an
increase in income taxes, he or she can simply substitute lower income with more fringe benefits and other job
amenities and avoid paying the income tax by switching their “compensation” from income to some other
thing. Low-skilled workers in low-paid work do not have these options and cannot avoid income taxes
simply by changing the nature of their total compensation.
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b. Another way governments have tried to collect taxes from the wealthy is
through the use of luxury taxes, which are exactly what they sound like: taxes
on goods that are considered luxuries, like jewelry or expensive cars and real
estate. What is true about the demand for luxuries? Consider jewelry. Is a
luxury tax more likely to hurt the buyers of jewelry, or the sellers of jewelry?

A: The demand for luxuries is necessarily elastic. If the supply of these goods
is not likewise elastic, then the buyers of luxuries will escape the luxury tax
and it will be borne primarily by the sellers of luxuries, like jewelry.

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PS5: Consider the supply and demand diagram below. In this market, the
government subsidizes the production of this good, and the subsidy wedge is
indicated.
a. Without the subsidy, which area(s) represent the total gains
from trade?

A: Total gains from trade without the subsidy are A + B + G + H.

b. After the subsidy, which area(s) represent consumer surplus?

Which area(s) represent producer surplus? Which area(s)
represent total government spending on this subsidy?

A: After the subsidy, consumer surplus is A + B + E + F + G;

producer surplus is B + C + G + H. Total government spending
on the subsidy is B + C + D + E + F + G.

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c. Which area(s) in part b showed up in the answer to more than one of the
questions? Can you explain this?

A: Areas B and C were a part of producer surplus and

government spending. Areas E, F, and G were part of
consumer surplus and government spending. In this
case, the government is paying for the increases in
surplus for consumers and producers. So, these areas
show up as additions to the surplus of consumers and
producers, but they are subtracted overall because
government paid for this surplus. Area D, the only part
of government spending that did not go to buyers or
sellers, is the area of deadweight loss caused by the
subsidy. It represents a government payment that did
not benefit anyone.

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C3: a. In the two figures below, one is a case where the sellers of windmills
have an elastic supply and the buyers of windmills (local power companies)
have inelastic demand. In the other case, the reverse is true. Which is which?

A: In the first graph,

supply is relatively
elastic and demand
relatively inelastic.

In the second graph,

supply is relatively
inelastic and demand
is relatively elastic.

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b. In which case will a subsidy cut the price paid by the buyers the most:
When demand is elastic or when it is inelastic? (It’ll be easiest if you use the
“wedge trick.”) Is this the first or second graph?

A: The price paid by the

buyers will fall the
most if demand is
inelastic (first graph).

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c. In which case will a subsidy increase the price paid to the sellers the most:
When supply is elastic or when it is inelastic? Again, which graph is this?

A: The price received by

the sellers will rise the
most if supply is inelastic
( second graph).

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d. Now look at how producer surplus and consumer surplus change in these
two cases. To see this, remember that producer surplus is the area above the
supply curve and below the price, and consumer surplus is the area below the
demand curve and above the price. So, in the first graph, who gets the lion’s
share of any subsidy-driven extra surplus: suppliers or demanders? Is that the
inelastic group or the elastic group? In other words, whose surplus triangle gets
bigger faster as the quantity increases?

A: The party who is more inelastic gets the biggest boost to surplus as the
subsidy grows. In the first group, that’s the demanders, with a steep demand
curve and hence an inelastic demand for windmills.

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e. Now it’s time for the second graph. Again, who gets the lion’s share of any
subsidy-driven extra surplus: suppliers or demanders? Is that the inelastic group
or the elastic group?

A: This time, it’s the suppliers, who again have an inelastic supply.

f. There’s going to be a pattern here in parts d and e: The more [elastic or

inelastic?] side of the market gets most of the extra surplus from the subsidy.

A: The more inelastic side of the market gets most of the benefit from the extra
surplus.

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C4: As you learned in the chapter, the elasticities of demand and supply
are crucial in determining how the burden of a tax (or the benefit of a
subsidy) is divided between buyers and sellers. Under what conditions for
supply or demand would a seller actually be able to avoid bearing any of
the burden of a tax? Under what conditions would a subsidy benefit only
the sellers of a good?

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A: For the seller to completely escape the
tax, the elasticity of supply would have to
be totally, or perfectly, elastic. This means
that the supply curve would have to be
horizontal, as in Panel A below. In this
case, the tax wedge would simply increase
the price paid by buyers, and not affect the
seller price.

Alternately, sellers could avoid the tax if

buyers had no ability to escape—that is, if
demand was perfectly inelastic, or vertical,
as in Panel B below. In this case, the wedge
would just sit right on top of the old
equilibrium and drive up the buyer price
without reducing the seller price.

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A (Cont.): The conditions
would have to be reversed for a
seller to enjoy all of the benefits
of a subsidy:

either perfectly elastic demand

(shown in Panel C below) or
perfectly inelastic supply
(shown in Panel D below).

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C5. In the chapter, most of the taxes we discussed were equal to a certain
dollar amount per unit. In this case, a tax on sellers results in a parallel
upward shift of the supply curve; a tax on buyers results in a parallel
downward shift of the demand curve.

In reality, however, many taxes are expressed as a percentage.

 Graphically, how would you show a 100% tax on the sellers of a good?
 Graphically, how would you show a 100% tax on the buyers of a good?
 One of the results of this chapter is that it doesn’t matter on whom the tax
is levied—the result is the same. Show graphically that this also applies to
percentage taxes.

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