1. Explain briefly why generally government shouldn’t place taxes in markets tha
ID: 1204345 • Letter: 1
Question
1. Explain briefly why generally government shouldn’t place taxes in markets that have pre-existing distortions. Be specific. Give an example where taxes can improve the distortion
2. Suppose the demand for apples is perfectly elastic and the government levies a tax t on the producers of apples. Assume that the supply of apples is neither perfectly elastic nor perfectly inelastic (upward sloping)
a. Explain using a graph how the price paid by consumers will change.
b. What is the statutory burden of the tax ? Which party bears the largest economic burden?
c. Is this change larger or smaller than the price change that would result if demand for apples were not perfectly elastic?
d. How would the quantities of apples consumed change because of the tax? Is this change in quantity larger or smaller than the change that would result if the demand for apples were not perfectly elastic?
Explanation / Answer
(1) Market is the connecting medium through which transactions take place in the economy. As two parties invloved in a market are consumers and producers, they create demand and supply in the market. These two variables depend on price. Demand is inversly related with price, but supply will be positively related. Market mechanism interacts with demand and supply to determine market equilibrium price. If the demand and supply are equal, then market is stable. No distortion is there. So in a distorted market demand will not match with supply. In this situation, imposition of tax will increase distortion further. It will happen, if demand is less than supply. If tax is imposed, net money/income available to consumers will decrease. It will reduce the demand in the market. Thus distortion will rise.
The position can improve if in the distorted market demand is more than supply. Imposition of tax will increase the cost/price of goods bought. So demand will decrease and will become at par with the supply. Thus distrortion will be over.
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2 (a):
Perfectly elastic demand is a situation when price of the commodity will remain constant and demand may change. So demand curve will be horizontal. In this situation, imposition of tax will shift the curve upward. If suply curve is upward rising, then market equilibrium point will shift to the right from point e1 to e2. So both equilibrium price and quantity will increase. But there is no guarantee of prevailing this equilibrium condition. Actual demand, due to its perfectly elastic nature, will change in any direction. So market can be distorted.
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(b) Tax is legally compulsory to pay. The person on whom the tax is imposed has to pay it. So statutory burden of paying tax lies on them. But sometimes this burden of colecting tax and depositing them to Federal lies on other person. Indirect tax like sales tax, customes duties are collected by a person other than its payer and deposits to exchequer. But burden of payment of tax lies on the person who has statutory burden. Consumers are the party on whom maximum burden is imposed. They are paying both direct and indirect tax. Business sector is also recovering the tax imposed on them from consumers by including them in the sales price.
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(c)
If the demand of Apple is perfectly elastic, then demand of apple can change even if price is constant. So the curve is horizontal in shape. Since demand is changing inspite of no change in price, value of elasticity will be infinitely large.
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(d) As the curve is infinitely elastic, demand may change in any direction even if price remains constant. Imposition of tax, will shift the curve paralely upward, but the demand can change in any direction. If the dmand is not perfectly elastic, then imposition of tax will reduce the demand of apple, due to inverse nature of price demand relation.
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